ReservedSchool of Distance EducationInternational Economics Page 3Semester VI International Economics EC6 B13a. Introduction:International economics deals with the economic relations among nations - both trade and financial.A good understanding of international economics is necessary of student of Economics and those whowish to work in these areas or governmental organizations.b. Objectives:The basic aim of this introductory course on international economics is to present before the studentsthe questions, and answers, related to international economic relations.c. Learning Outcome:The students are expected to acquire skill that will help them to take rational decisions in Issuesrelated international economics.d. SyllabusModule 1: Introduction to International EconomicsImportance of International Trade - Internal Trade and International TradeModule 2: Theories of International TradeClassical Theory: Absolute and Comparative cost Advantage theories, - .Hecksher Ohlin Theoryand Leontief Paradox.Module 3: Theory of Commercial Policy:Arguments for and against Free Trade - Arguments for and Against Protection - Methods of TradeRestriction: Tariff Non-Tariff trade barriers Dumping, export subsidy and Countervailing duties.(Concept only) - Economic Integration EU, NAFTA, ASEAN, SAARC, WTO.Module 4: Foreign Exchange:Defining foreign exchange and exchange rate - Components of foreign exchange reserve. - Differentsystems of exchange rate determination: gold standard (Mint Parity), PPP, Floating exchangerate,Fixed and Flexible Exchange rate. (Concepts only) - Devaluation, revaluation, depreciation andappreciation.Module 5: Balance of PaymentsDefining Balance of Trade and Balance of Payment. - Equilibrium and disequilibrium in BOP -Measures to correct BOP disequilibrium. - BOP in India.Reference:1. Salvatore, Dominick, International Economics, Weily India New Delhi.2. C.P. Kindle Berger International Economics3. Bo Soderstein and Geoffrey Reed International Economics Macmilon4. Francis Cherumilam - International Economics5. Mannur, H.G. International Economics6. Errol DSouza, Macro Economics, Pearson Education 2008 (For BOP in India)7. RBI bulletin, various issues.School of Distance EducationInternational Economics Page 4School of Distance EducationInternational Economics Page 5MODULE IINTRODUCTION TO INTERNATIONAL ECONOMICSInternational Economics is a specialized branch of Economics focusing on the externaltrading relations of nations. Generally external trade involves the exchange of goods and servicesamong nations crossing the national territories. Trade not only strengthens the economicinterdependence among nations but promotes consumer welfare also by providing a variety ofcommodities. Since it involves several countries a different set of rules and regulations arenecessary for the smooth functioning of the system. This is why international economics is treatedas a separate branch of study.Broadly the subject matter in International Economics can be categorized into five broadgroups.1. International Trade TheoryIt concentrates on the theoretical aspects of trade like reasons of trade, gains of trade etc.Different schools of theories are discussed in this section.2. International Trade PolicyThis area deals with the international rules and regulations regarding the flow oftransactions. It includes various trade restrictions like tariffs, quotas, changes in exchangerates etc. The regulatory mechanisms and various international institutions for monitoringit are also come under this section.3. Balance of PaymentWith the progress of trade, nations have to make and receive payments. All theseeconomic transactions of a nation with the rest of the world are systematically recorded inthis account. The fluctuations in BOP and the associated policy regulations are alsoincluded in this section.4. Balance of Payment Adjustments or Open Economy MacroeconomicsWith the progress of transactions, sometimes either the credit or the debit may outweighthe other side. It will lead to imbalances in BOP. This situation is normally coined BOPdisequilibrium which demands correction either automatically or externally imposed bythe governments. The external repercussions are also brought into the study.5. International OrganizationsInternational trade is a complex activity involving multiple countries and currencies.Commodities and capital flow across countries. Hence it requires separate rules andregulations. It should be monitored by international level organizations also. All theseaspects are monitored under the head global economic organizations.School of Distance EducationInternational Economics Page 6TRADE AND DEVELOPMENTInternational trade is closely linked to development. Most fast growing economies alsohave a dynamic trade sector. When a firm or an individual buys a good or a service producedmore cheaply abroad, living standards in both countries increase. There are other reasonsconsumers and firms buy abroad that also make them better offthe product may better fit theirneeds than similar domestic offerings or it may not be available domestically. In any case, theforeign producer also benefits by making more sales than it could selling solely in its own marketand by earning foreign exchange (currency) that can be used by itself or others in the country topurchase foreign-made products.The gains(importance) of trade is generally reflected in thefollowing manner.Acquisition of Capital Goods Industries: The under-developed countries (UDCs) areenabled by foreign trade to obtain in exchange for their goods capital equipment and heavyengineering machines to foster their countries economic development. For example, Indiaexports spices, cotton and cotton textiles, marine products, germs and jewellery and in exchangewe import heavy machienery, defence equipments, and other capital equipment from thedeveloped countries.Market Extension The foreign trade can extend the scope of the business to theinternational market. The domestic market is limited; the foreign trade sector opens new vistas,new marketing channels and new markets. When the markets are extended, the economies ofscale are reaped; the efficiency and productivity will increase. Accordingly, the forces ofdevelopment will set themselves in motion.Foreign Investment: The foreign trade is also helpful in attracting foreign investment.The foreign investors are attracted towards active trading countries and invest in the form ofcapital goods and technical expertise. In this way, the assembling plants, the manufacturing plantsand the latest technology will come into the country. Foreign Direct Investments and off shoringwill stimulate the economic climate of a nation.National Income: When there is imports and exports of goods and services, thegovernment can earn the revenue in form of tariffs, custom duty, import licence fees, etc.Employment Opportunities: Moreover, the external sector also opens the employmentopportunities for the country-men in the foreign countries. Hundreds of thousands of Indians areworking abroad. India is earning billions of dollars through foreign exchange remittances andstands in the second position just behind China. Therefore, such remittances are proved to be amajor source of foreign exchange earnings.School of Distance EducationInternational Economics Page 7MODULE 2THEORIES OF INTERNATIONAL TRADEINTRODUCTIONInternational trade theories postulate different aspects of trading practices like basis fortrade (reasons for trade), terms of trade (exchange ratio between products), and the gains fromtrade. It also helps to predict the size, content and direction of trade flows. Depending on thedifferences of arguments various economists put forward different models of trade pattern. Thethree phases of the trade theories are pre classical, classical and modern schools. Mercantilismrepresents the pre classical version. Adam Smith, David Ricardo and John Stuart Mill areassociated with the classical theory. The modern version is linked with two Swedish economistsEli Heckscher and Bertil Ohlin.MERCANTILISMThe trade theory that states that nations should accumulate financial wealth, usually in theform of gold, by encouraging exports and discouraging imports is called mercantilism. Ratherthan a full fledged trade theory it was actually an economic policy of wealth accumulation.According to this theory other measures of countries' well being, such as living standards orhuman development, are irrelevant. They simply focused on the accumulation of gold. MainlyGreat Britain, France, the Netherlands, Portugal and Spain used mercantilism during the 1500s tothe late 1700s. Mercantilism proposed that a country should try to export more than its imports, inorder to receive gold. For this they advocated strict controls on trade in the form of tariffs andquotas. Mercantilist countries practiced the zero-sum game, which meant that world wealth waslimited and that countries could increase their share only at the expense of other countries. Thisprotectionist policy decelerated the long term growth.Features Restrictive trade aiming at the acceleration of exports and reduction of imports Strict focus on the wealth accumulation than welfare promotion No simultaneous gains or sharing of gains among countries are possible. One country canbenefit only at the cost of other countries Adoption of trade protectionismOwing to these unrealistic practices it faded in the following era. Later by the publicationof Wealth of Nations by Adam Smith this doctrine completely lost its relevance. But in recenttimes it is slowly emerging with slight variations. Neo mercantilism is the modern version ofmercantilist practices, through the formation of local trading blocks and promotion of trade withimposition of tariffs and quotas.School of Distance EducationInternational Economics Page 8LABOUR THEORY OF VALUEIt is the foundation stone of classical trade theories. It states that the value of a commodityis solely depended on the amount of labour hours utilized for its production. It assumes that thereare no other factor inputs are used for production. Commodities are exchanged also on this basisof labour content. For example if a jeans is made out of 8 hours of labour and a toy of 4 hoursthen 2 toys are required to exchange for one jeans. Nowadays it seems to be meaningless but atthat time technology was less developed and barter system was prevalent.THEORY OFABSOLUTE ADVANTAGE: ADAM SMITHThe Scottish economist Adam Smith developed the trade theory of absolute advantage in 1776through his legendary book An Enquiry into the Nature and Causes of Wealth of Nations. Hedeveloped the theory as an attack against the then prevailing mercantilist view of restrictive tradewith the slogan free trade. Smith's argument was that the wealth of nations depends upon thegoods and services available to their citizens, rather than the gold reserves held by the nation.Maximizing this availability depends primarily on fuller utilization of resources and then, on theability to obtain goods and services from where they are produced most cheaply (because ofnatural or acquired advantages), and to pay for them by production of the goods and services produced most cheaply in thecountry,Human skill up gradation, division of labour and specialization and the economies of scaleare the sources of acquired advantage for cheaper production. Natural advantages mayemerge out of natural factors.As the name indicates this theory proposes that a country should engage in the productionand exchange of those commodities where it has an absolute advantage. Such a country producesgreater output of a good or service than other countries using the same amount of resources.Absolute advantage is defined as the ability to produce more of a good or service thancompetitors, using the same amount of resources. Smith stated that tariffs and quotas should notrestrict international trade; it should be allowed to flow according to market forces. Contrary tomercantilism Smith argued that a country should concentrate on production of goods in which itholds an absolute advantage. No country would then need to produce all the goods it consumed.The theory of absolute advantage destroys the mercantilist idea that international trade is a zero-sum game. According to the absolute advantage theory, international trade is a positive-sumgame, because there are gains for both countries to an exchange.School of Distance EducationInternational Economics Page 9Assumptions There are two countries and two commodities One country has absolute advantage in one commodity and the second country hasadvantage in another commodity Technology is assumed to be constant Labour is the only factor of production labour is homogeneous, that means each unit of labour produces same level of output value of a commodity is measured in terms of its labour content There is no technological improvement Labour is perfectly mobile within the country but perfectly immobile between thecountries. It means that workers are free to move between industries within the nation butmigration to other countries is impossible. A system of barter prevails Zero transportation costBased on these assumptions the theory can be explained with an example. Suppose thereare two countries- India and Cuba producing tea and sugar. By employing a worker for one hourIndia can produce either 10kilograms of tea or 5 kilograms of sugar. Similarly if a Cuban workeris employed she is capable of producing 10 kilograms of sugar or 5 kilograms of tea.Table 1: Output per hour (kg)Country Sugar TeaIndia 5 10Cuba 10 5From the table it is clear that by spending an hours labour India is capable of producingtwofold of tea than Cuba similarly in the case of sugar Cuba is able to generate double theproduction in India. In short Cuba has absolute advantage in sugar and India in tea. In thissituation by concentrating on the respective absolute advantageous areas both nations can benefitby fully channelizing their resources to absolutely advantageous commodity.Since there is perfect factor mobility within a country, India can channelize labourers intotea sector and Cuba into sugar industry. If India transfer one labour from sugar to tea sector sugarproduction may fall by 5 kilograms but can produce 10 more kilograms of tea. By exchanging thisone unit effort India is capable of purchasing 10 kilograms of sugar from Cuba. So it is beneficialfor India. If India goes for domestic exchange, due to the increased cost it will not benefit India.The same is true for Cuba in the case of sugar.There is a potential problem with absolute advantage. If there is one country that does not have anabsolute advantage in the production of any product, will there still be benefit to trade, and willtrade even occur? The answer may be found in the extension of absolute advantage, the theory ofcomparative advantage.School of Distance EducationInternational Economics Page 10COMPARATIVE ADVANTAGE: DAVID RICARDOThe most basic concept in the whole of international trade theory is the principle ofcomparative advantage, first introduced by David Ricardo in 1817. It remains a major influenceon much international trade policy and is therefore important in understanding the modern globaleconomy. Comparative advantage is the ability of a firm or individual to produce goods and/orservices at a lower opportunity cost than other firms or individuals. A comparative advantagegives a company the ability to sell goods and services at a lower price than its competitors andrealize stronger sales margins. David Ricardo stated in his theory of comparative advantage that acountry should specialize in producing and exporting products in which it has a comparativeadvantage and it should import goods in which it has a comparative disadvantage. Out of suchspecialization, it will accrue greater benefit for all.Assumptions There are two countries and two commodities One country has absolute advantage in both commodities and the second country has inanother commodity Technology is assumed to be constant Labour is the only factor of production labour is homogeneous, that means each unit of labour produces same level of output Technology is assumed to be constant value of a commodity is measured in terms of its labour content There is no technological improvement Labour is perfectly mobile within the country but perfectly immobile between thecountries. It means that workers are free to move between industries within the nation butmigration to other countries is impossible. A system of barter prevails Zero transportation costExample:Table 2: Output per hour (kg)Country Wheat TeaIndia 10 10Burma 4 5In this example Indian labourers are capable of producing both wheat and tea in absoluteadvantage. Burma is disadvantageous in both cases. But still there is a possibility for trade. Burmahas fewer disadvantages in tea than wheat. So it is its comparative advantage. If Indiaconcentrates in wheat it is capable of producing more than two fold wheat, but in tea it canproduce only two fold than Burma. Although India has an absolute advantage in the production ofboth tea and wheat, India has a comparative advantage only in the production of wheat. This isbecause its advantage in wheat is comparatively greater than its advantage in tea. In this situationIndia can concentrate on wheat and Burma on tea and both can benefit from trade.School of Distance EducationInternational Economics Page 11In this theory there are several assumptions that limit the real-world application. Theassumption that countries are driven only by the maximization of production and consumptionand not by issues out of concern for workers or consumers is a mistake.RECIPROCAL DEMAND THEORY: J S MILLComparative advantage explains the pattern of trade. It also furnishes a strong argumentfor trade gains and tells much about readjustment of production and the basic laws that determinethe real rate of exchanges between the exportable and importable goods. But to explain the actualpattern of production, or the exact terms at which one countrys products exchange for those ofanother, we also need detailed knowledge of demand and supply. This was firstly verbalized byJohn Stuart Mill through the reciprocal demand theory and then put into graphic form by AlfredMarshall and F.Y. Edgeworth using the offer curves.Mill firstly revealed the mechanism of how to determine the rate of exchange ininternational market and how to distribute the total gains from trade between the two traders bydetailing specific relationship between them. That is the two participants of trade in Ricardianmodel must establish a specific relationship with each other, this is the reciprocal demandrelationship. It is this reciprocal demand that actually determines the prevailing terms of tradeand how much gains obtained by a particular country. The reciprocal demand can be defined asthe demand for imports in terms of the export of the country.In other words John Stuart Mill had resolved the problem of how to exactly reach the rateof exchange in international market. Comparative advantage and law of reciprocal demand byJohn Stuart Mill constitute the two basic building blocks of the classical theory of internationaltrade. Mill argued, acquisition of imports from abroad is the purpose of trade while exports arejust means of payment for imports. In order to import some useful commodities from abroadexports of a country should have a real demand in the other countries. So a country shouldproduce both for itself and for consumers in the other countries. Otherwise its exports could notbe sold in international market and consequently the country could not import any commodities atall.Reciprocal demand and terms of tradeThe value, then, in any country, of a foreign commodity, depend upon the quantity ofhome produce which must be given to the foreign country in exchange for it. In other words, thevalues of foreign commodities depend upon the terms of international exchange. It is not theircost of production rather the law of supply and demand that determines the terms of internationalexchanges.School of Distance EducationInternational Economics Page 12HECKSCHER OHLIN THEORYIn the early 20th century, Swedish economists Eli Heckscher and Bertil Ohlin identifiedthe role of labor and capital, so-called factor endowments, as a determinant of advantage. In 1979Ohlin was awarded Nobel Prize jointly with James Meade for his work in international tradetheory. The Heckscher-Ohlin proposition maintains that countries tend to export goods whoseproduction uses intensively the factor of production that is relatively abundant in the country.Countries well endowed with capitalsuch as factories and machineryshould export capital-intensive products, while those well endowed with labor should export labor-intensive products.According to Bertil Ohlin, trade arises due to the differences in the relative prices of differentgoods in different countries. The difference in commodity price is due to the difference in factorprices (i.e. costs). Factor prices differ because endowments (i.e. capital and labour) differ incountries. Hence, trade occurs because different countries have different factor endowments.The Heckscher Ohlin theorem states that countries which are rich in labour will exportlabour intensive goods and countries which are rich in capital will export capital intensivegoodsHeckscher-Ohlin's theory explains the modern approach to international trade on the basisof following assumptions :-1. There are two countries involved.2. Each country has two factors (labour and capital).3. Each country produce two commodities or goods (labour intensive and capital intensive).4. There is perfect competition in both commodity and factor markets.5. All production functions are homogeneous of the first degree i.e. production function issubject to constant returns to scale.6. Factors are freely mobile within a country but immobile between countries.7. Two countries differ in factor supply.8. Each commodity differs in factor intensity.9. The production function remains the same in different countries for the same commodity.For e.g. If commodity A requires more capital in one country then same is the case inother country.10. There is full employment of resources in both countries and demand are identical in bothcountries.11. Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.12. There are no transportation costs.Given these assumption, Ohlin's thesis contends that a country export goods which use relativelya greater proportion of its abundant and cheap factor. While same country imports goods whoseproduction requires the intensive use of the nation's relatively scarce and expensive factor.School of Distance EducationInternational Economics Page 13Understanding The Concept of Factor AbundanceIn the two countries, two commodities & two factor model, implies that the capital richcountry will export capital intensive commodity and the labour rich country will export labourintensive commodity. But the concept of country being rich in one factor or other is not veryclear. Economists quite often define factor abundance in terms of factor prices. Ohlin himself hasfollowed this approach. Alternatively factor abundance can be defined in physical terms. In thiscase, physical amounts of capital and Labour are to be compared.Price Criterion for defining Factor AbundanceA country where capital is relatively cheaper and labour is relatively costly is said to becapital rich country. Whereas a country where labour is relatively cheaper and capital is relativelycostly is said to be labour rich country.Explaining Heckscher Ohlin's H-O TheoryLet us take an example of same two countries viz; England and India where England is acapital rich country while India is a labour abundant nation.In the above diagram XX is the isoquant (equal product curve) for the commodity X produced inEngland. YY is the isoquant representing commodity Y produced in India. It is very clear that XXis relatively capital intensive while YY is relatively labour incentive. The factor capital isrepresented on Y-axis while the factor labour is represented on the horizontal X-axis.PA is the price line or budget line of the country England. The price line PA is tangent to XX at E.The price line PA is also tangent to YY isoquant at K. The point K will help us to find out howmuch of capital and labour is required to produce one unit of Y in England.P1B is the price line of the country India, The price line P1B is tangent to YY at I. The price lineRS which is drawn parallel to P1B is tangent to XX at M. This will help us to find out how muchof capital and labour is required to produce one unit of commodity X in India.Under the given situations, the country England will choose the combination E. Which meansmore specialisation on capital goods. It will not choose the combination K because it is morelabour intensive and less capital intensive.Thus according to Ohlin, England will specialise on production of goods X by using the cheapfactor capital extensively while India specialises on commodity Y by using the cheap factorlabour available in the country.School of Distance EducationInternational Economics Page 14The Ohlin's theory concludes that :-1. The basis of internal trade is the difference in commodity prices in the two countries.2. Differences in the commodity prices are due to cost differences which are the results ofdifferences in factor endowments in two countries.3. A capital rich country specialises in capital intensive goods & exports them. While aLabour abundant country specialises in labour intensive goods & exports them.Limitations of Heckscher Ohlin's H-O Theory: Heckscher Ohlin's Theory has beencriticised on basis of following grounds :-1. Unrealistic Assumptions : Besides the usual assumptions of two countries, twocommodities, no transport cost, etc. Ohlin's theory also assumes no qualitative differencein factors of production, identical production function, constant return to scale, etc. Allthese assumptions makes the theory unrealistic one.2. Restrictive : Ohlin's theory is not free from constrains. His theory includes only twocommodities, two countries and two factors. Thus it is a restrictive one.3. One-Sided Theory : According to Ohlin's theory, supply plays a significant role thandemand in determining factor prices. But if demand forces are more significant, a capitalabundant country will export labour intensive good as the price of capital will be high dueto high demand for capital.4. Static in Nature : Like Ricardian Theory the H-O Model is also static in nature. Thetheory is based on a given state of economy and with a given production function and doesnot accept any change.5. Wijnholds's Criticism : According to Wijnholds, it is not the factor prices that determinethe costs and commodity prices but it is commodity prices that determine the factor prices.6. Consumers' Demand ignored : Ohlin forgot an important fact that commodity prices arealso influenced by the consumers' demand.7. Haberler's Criticism : According to Haberler, Ohlin's theory is based on partialequilibrium. It fails to give a complete, comprehensive and general equilibrium analysis.8. Leontief Paradox : American economist Dr. Wassily Leontief tested H-O theory underU.S.A conditions. He found out that U.S.A exports labour intensive goods and importscapital intensive goods, but U.S.A being a capital abundant country must export capitalintensive goods and import labour intensive goods than to produce them at home. Thissituation is called Leontief Paradox which negates H-O Theory.9. Other Factors Neglected : Factor endowment is not the sole factor influencingcommodity price and international trade. The H-O Theory neglects other factors liketechnology, technique of production, natural factors, different qualities of labour, etc.,which can also influence the international trade.School of Distance EducationInternational Economics Page 15There are four major components of the HO model:1. Factor Price Equalization Theorem,2. Stolper-Samuelson Theorem,3. Rybczynski Theorem, and4. Heckscher-Ohlin Trade Theorem.Factor Price Equalization Theorem: Among the four main results of the HO theory, FPE is themost fragile theorem. If any of the eight assumptions is violated, it will not hold. However,perhaps this is the single most important finding in trade theory; it shows how trade affectsincome distribution of the global economy. It states that international trade will bring aboutequalization in the returns to homogeneous factors across countries.Stolper-Samuelson Theorem: The theorem intends to show that the change in commodity priceschange the distribution of real incomes between capital and labor. It states that the internationaltrade will reduce the income of the scarce factor of production and increase the income of theabundant factor of the country. This is because when trade promotes nations will exportcommodities which are intensive in its abundant and cheap factor. This will earn more income tothat factor. Since imports are on the scarce factor the income will flow to abroad leading to a netdecline in its earnings.Rybczynski Theorem: It states that at constant commodity prices, an increase in the quantity ofone factor increases the production of the commodity intensive in this factor and reduces theoutput of the other commodity which is intensive in the constant factor. For example if labourforce increase in a country and it turns to be more profitable to employ them , then naturally thecountry intensify the production of labour intensive commodities at the cost of capital intensivecommodity.Heckscher-Ohlin Trade Theorem: It maintains a country will produce and export thosecommodities in which its abundant factor is intensively used and import those commodities inwhich the relatively scarce factor is immensely used.LEONTIEFS PARADOXIn 1953, Wassily Leontief published a study named, "Domestic production and foreigntrade: the American capital position re-examined" where he tested the validity of the Heckscher-Ohlin theory. Using data available from the 1947 input-output (I-O) model of the US economy,Leontief calculated the K and L requirements for the production of $1 million of US exports and$1 million of US production in import-competing industries. He found that the former required ahigher proportion of L than the latter. The study showed that the U.S was more abundant incapital compared to other countries, therefore the U.S would export capital- intensive goods andimport labour-intensive goods. Leontief found out that the U.S's export was less capital intensivethan import. Hecksher-Ohlin's theory of factor endowments stressed that a country shouldproduce and export goods that require resources (factors) that are abundant in the home country.Leontief tested the Hecksher-Ohlin theory in the U.S. and found that it was not applicable in theU.S.School of Distance EducationInternational Economics Page 16Possible explanations of the Leontief paradox1. US demand for K-intensive products outstripped its capacity to provide them domestically. Sothere was no other alternative than imports.2. "Factor-intensity reversal" Leontief had no idea of the input mix for manufacturing in othercountries; he measured the K-intensity of US production in import-competing industries, not ofUS imports. If L is expensive in the US, then US industries facing import competition would haveto reduce their use of L, by substituting K. However, this would mean that production functions(i.e., input mix; technology) vary for the same products in different places, which renders theHeckscher-Ohlin theorem nearly useless.3. Perhaps international trade flows were not rationalized according to comparative advantage in1947, immediately after the destruction and disruption of World War 2. After all, comparativeadvantage is a normative concept. 4. The US imported natural-resource commodities whoseextraction is K-intensive, but in which other nations have an absolute advantage.4. "Human-skills theory" L is a heterogeneous factor, and should be analyzed as separatefactors according to skills levels. Perhaps the US is actually skilled- and technical-L rich, andtherefore has a comparative advantage in production that requires much skilled or technical L. H-O formulations should be expanded to allow for more than one L factor. [Difficult to test, but canbe added to the H-O theorem]. Related to this is the recognition of international differences infactor productivity. US labor is more productive than the labor of most countries (because ofskills, work organization, capital/worker, and technology), and is paid more per hour; this helpsexplain why US labor looms larger as a cost in US exports.5. Technology itself is a nation-specific factor of production, rather than being a universalattribute of production. Furthermore, technology is a factor that is produced within a given nation(much like a commodity), but is not perfectly mobile or tradable. This kind of thinking has led to"neo-technology theories of trade").6. The US Government and private companies lent (or otherwise invested) so much capital inparticular sectors of particular foreign economies, that these enclaves became, essentially, capital-rich. [Thanks, Mike, for this suggestion. Empirically, it probably doesn't play an important role inLeontief's 1947 data, but it (a) does conceptual damage to the factor-proportions theory because itimplies that capital, a factor, is mobile, and (b) it presages the model of the international productlife cycle, below].School of Distance EducationInternational Economics Page 17TERMS OF TRADE:It is the ratio of export prices to import prices of the country. It is a measure of theexchange of exports and imports or how much a nation can import in terms of its exports. Ifexport prices exceed the import prices it will be favorable to the home country and vice versa. Itcan be stated as:Terms of Trade = Export prices/ Import prices = Px/PmNet barter Terms of Trade (N)This is the ratio of price index of exports to the price index of importsN = Px/Pm X 100Gross Barter Terms of Trade (G)It is the ratio of quantity of imports to quantity of exportsG = Qm/Qx X 100Income Terms of Trade (I)It is the product of net barter terms of trade and the quantity of exports. It is a yardstick of acountrys capability to import based on its export earnings.I = Px/Pm X QxSchool of Distance EducationInternational Economics Page 18MODULE 3THEORY OF COMMERCIAL POLICYBut, in general, the protective system of our day is conservative, whilethe free trade system is destructive. It breaks up old nationalities andpushes the antagonism of the proletariat and the bourgeoisie to theextreme point. In a word, the free trade system hastens the socialrevolution. It is in this revolutionary sense alone, gentlemen that I vote infavor of free trade.-Karl MarxFREE TRADEFree trade may be defined as a policy of a government which does not discriminate againstimports or interfere with trade by applying tariffs (to imports) or subsidies (to exports). In otherwords it is the unrestricted purchase and sale of goods and services between countries without theimposition of constraints such as tariffs, duties and quotas. Free trade enables nations to focus ontheir core competitive advantages, thereby maximizing economic output and fostering incomegrowth for their citizens. The idea that free trade is welfare enhancing is one of the mostfundamental doctrines in modern economics dating back at least to Adam Smith (1776) and DavidRicardo (1816). But the policy of free trade has been in controversy all the time because thecountries were not taking choice between free trade and autarky (no trade). They always chooseone policy from among a spectrum of free trade regimes with varying degrees of liberalization.Here are some arguments which are placed in favour of the free trade regime.1. The theory of comparative advantageThis explains that by specializing and trading goods in which countries have a lower opportunitycost or greater comparative advantage, there can be an increase in economic welfare for allcountries. Free trade enables countries to specialize in those goods where they have a comparativeadvantage. Free trade in lines of comparative advantage is expected to mutually benefit thecountries engaged in free trade.2. Trade as a vent for surplus.Trade is identified as a vent for surplus output of an economy. The dictum is related to Adamsmith who identified the importance of division of labour. Smith also maintained that the divisionof labour is limited by the size of the market. Hence division of labour is expected to raise thedomestic production. A deficiency in Aggregate demand may reduce the domestic prices. Heretrade can act as a vent for surplus production brought forth through technology and division oflabour. Free trade is expected to smoothen this process.School of Distance EducationInternational Economics Page 193. Reducing Tariff barriers leads to trade creationTrade creation occurs when consumption switches from high cost producers to low costproducers. Reducing the tariff barriers with an objective to bring about free trade in an economymay help countries for trade creation. The following diagram explains the above idea. The removal of tariffs leads to lower prices for consumers and an increase in consumersurplus of areas 1 + 2 + 3 + 4 Imports will increase from Q3-Q2 to Q4-Q1 The government will lose tax revenue of area 3 Domestic firms producing this good will sell less and lose producer surplus equal to area 1 However overall there will be an increase in economic welfare of 2+4 (1+2+3+4 (1+3) The magnitude of this increase depends upon the elasticity of supply and demand. Ifdemand elastic consumers will have a big increase in welfare4. Economies of Scale.If countries can specialize in certain goods they can benefit from economies of scale and loweraverage costs. Economies of scale refer to the capacity of firms to change their output more thanproportionately to changes in inputs. This is especially true in industries with high fixed costs orthat require high levels of investment. The benefits of economies of scale will ultimately lead tolower prices for consumers. Lowering of trade restrictions enhances this outcome.5. Increased Competition.With more trade domestic firms will face more competition from abroad. As a result of this therewill be more incentives to cut costs and increase efficiency. It may prevent domestic monopoliesfrom charging too high prices.School of Distance EducationInternational Economics Page 206. Trade is an engine of growth.World trade has increased by an average of 7% since the 1945, causing this to be one of the bigcontributors to economic growth.7. Make use of surplus raw materialsMiddle Eastern counties such as Qatar are very rich in reserves of oil but without trade therewould be not much benefit in having so much oil. Japan on the other hand has very few rawmaterial without trade it would be very poor.8. Tariffs encourage inefficiencyIf an economy protects its domestic industry by increasing tariffs industries may not have anyincentives to cut costs. Trade liberalization is often justified in terms of the efficient marketoutcome and efficient price fixation through a competitive price fixing mechanism.Arguments against Free Trade1. Infant Industry Argument: Governments are sometimes urged to support thedevelopment of infant industries, protecting home industries in their early stages, usuallythrough subsidies or tariffs. Subsidies may be indirect, as in when import duties areimposed or some prohibition against the import of a raw or finished material is imposed.If developing countries have industries that are relatively new, then at the moment theseindustries would struggle against international competition. However if they invested inthe industry then in the future they may be able to gain Comparative Advantage.2. The Senile industry argument: If industries are declining and inefficient they may requirelarge investment to make them efficient again. Protection for these industries would act asan incentive to for firms to invest and reinvent themselves. However protectionism couldalso be an excuse for protecting inefficient firms3. To diversify the economy: Many developing countries rely on producing primaryproducts in which they currently have a comparative advantage. However relying onagricultural products has several disadvantages. One of the most important determinants ofAgricultural Prices is the environmental factors. Hence they can fluctuate with climaticchanges. Agricultural commodities have a low income and price elasticity of demand.Therefore with proportionate rise in economic growth will lead to less than proportionaterise in demand. Agricultural commodities have relatively low price elasticity of supply. Aproportionate rise in prices will lead to less than proportionate rise in supply ofagricultural commodities. This is because of the time lag involved in the production ofagricultural goods. This is given by the fact that the production of agricultural goods attime t is determined by the prices prevailing in timet-1.4. Raise revenue for the govt: Import taxes and tariffs can be used to raise money for thegovernment.School of Distance EducationInternational Economics Page 215. Help the Balance of Payments: Reducing imports can help the current account. Howeverin the long term this is likely to lead to retaliation6. Cultural Identity: This is not really an economic argument but more political andcultural. Many countries wish to protect their countries from what they see as anAmericanization or commercialization of their countries7. Protection against dumping: The EU sold a lot of its food surplus from the CAP at verylow prices on the world market. This caused problems for world farmers because they sawa big fall in their market prices8. Environmental: It is argued that free trade can harm the environment because Developingcountries may use up natural reserves of raw materials to produce exportable commodities.Also countries with strict pollution controls may find consumers import the goods fromother countries where legislation is lax and pollution allowed.Trade RestrictionsRestrictions on international movement of goods and services can be divided into tariffbarriers and non tariff barriers. A tariff is a tax put on goods imported from abroad. The effectof a tariff is to raise the price of the imported product. It helps domestic producers of similarproducts to sell them at higher prices. The money received from the tariff is collected by thedomestic government. An import tariff is a duty on Import commodities and an export tariff is aduty on export commodities. Tariffs can be ad valoram specific or compound. An ad valoremtariff is expressed as a fixed percentage of the value of the traded commodity. For example if theUS government decides to levy a 10% ad valoram duty on the $100 worth bicycles that the USimports from India, the imported will have to pay $ 10 for each bicycle that he imports fromIndia. The specific tariff is expressed as a fixed sum per physical unit of the traded commodity.Here if the specific duty is specified as $5 then the customs officials have to collect $5 for eachbicycle that is imported to us from India irrespective of its price. A compound tariff is thecombination of the ad valorem and specific tariffs. Finally a compound duty of $15 on thebicycle imported to US will lead the customs officials to collect $5 as the specific part of thecompound duty and $10 - that is10 % if each $100 worth bicycle - as the ad valorem part of thecompound duty.Besides these classifications tariffs can be classified as protective and revenue tariffs.Protective tariffs are put in place specifically to make foreign good more expensive to protectdomestic industries from competition. Revenue tariffs are put in place to raise money for thegovernment. It all depends on the intention of the government that implements the tariff.School of Distance EducationInternational Economics Page 22Non-Tariff Trade BarriersNon-tariff barriers to trade (NTBs) are trade barriers that restrict imports but are not inthe usual form of a tariff. Some common examples of NTB's are anti-dumping measures andcountervailing duties, which, although called non-tariff barriers, have the effect of tariffs oncethey are enacted. Non-tariff barriers to trade include import quotas, special licenses, unreasonablestandards for the quality of goods, bureaucratic delays at customs, export restrictions, limiting theactivities of state trading, export subsidies, countervailing duties, technical barriers to trade,sanitary and phyto-sanitary measures, rules of origin, etc.Their use has risen sharply after the WTO rules led to a very significant reduction in tariffuse. Some non-tariff trade barriers are expressly permitted in very limited circumstances, whenthey are deemed necessary to protect health, safety, sanitation, or natural resources. In otherforms, they are criticized as a means to evade free trade rules such as those of the World TradeOrganization (WTO), the European Union (EU), or North American Free Trade Agreement(NAFTA) that restrict the use of tariffs.A quota is a quantitative limit on the amount of goods that can be imported. Putting aquota on a good creates a shortage, which causes the price of the good to rise and allows domesticproducers to raise their prices and to expand their production. An import quota is a limit on thequantity of a good that can be produced abroad and sold domestically. It is a type of protectionisttrade restriction that sets a physical limit on the quantity of a good that can be imported into acountry in a given period of time. If a quota is put on a good, less of it is imported. Quotas, likeother trade restrictions, are used to benefit the producers of a good in a domestic economy at theexpense of all consumers of the good in that economy.DumpingDumping is international price discrimination. Price discrimination is usually practiced bya monopolist, and refers to charging different prices to same commodity for different people. Afirm may charge higher price for domestic consumers and a lower price for foreign consumers.This may be considered as a trade barrier.Two necessary conditions for price discrimination and dumping are:(i) The markets should be subdivided and the division should be so effective that thegoods sold in one market needs to be resold in another market.(ii) The price elasticity demand should be different in each market.Dumping is of different types. The following are the important types of dumping.(i) Persistent dumping(ii) Predatory dumping(iii) Sporadic dumpingSchool of Distance EducationInternational Economics Page 23(i) Persistent DumpingIt is a continuous tenancy of a domestic monopolist to maximize total profits by selling thecommodity at a higher price in the domestic markets than foreign market.(ii) Predatory DumpingIt is the temporary sale of a commodity at a lower price (may be low cost) in abroad inorder to drive foreign producers out of business.(iii) Sporadic DumpingSporadic Dumping is the occasional sale of a commodity at below cost at a lower priceabroad than domestically in order to unload an unforeseen and temporary surplus of thecommodity without having to reduce domestic prices.Trade restrictions to counteract predatory dumping are justified and allowed to protectdomestic industries from unfair competition from abroad. These restrictions usually take the formof antidumping duties to offset price differentials or the threat to impose such duties. Through thetrade restriction they discourage imports and promote their own products.Export Subsidies:-These are direct payments to nations exporters. Export subsidies are of different types.They include the practice of granting tax relief and subsidized loans to the nations exporters orpotential exporters, providing low interest loan to foreign buyers so as to stimulate the nationexports etc. Export subsidies as such may be regarded as a form of dumping.All the major industrial nations give low interest loans to foreign buyers of the nationsexport to finance the purchases. This is undertaken through agencies such as Export import Bank.These low interest credits are financing about 2% of US exports as compared with Japans 32%,Frances 18% and Germanys 9% indeed. This is the one of the most serious trade complaintsthat U.S has against many other industrial countries. The amount of subsidies can be measured bythe difference between the interest that would have been paid on a commercial loan and what isin fact gained at the subsidize rate. In 1996 U.S provided about 1 billion as such subsidies andJapan, France and Germany two or three times that amount.Countervailing Duties (CVDs)C.V.Ds is often imposed on imports to offset export subsidies by foreign Government.Duties that are imposed in order to counter the negative impact of import subsidies to protectdomestic producers are called countervailing duties. In cases foreign producers attempt tosubsidize the goods being exported by them so that it causes domestic production to sufferbecause of a shift in domestic demand towards cheaper imported goods, the government makesmandatory the payment of a countervailing duty on the import of such goods to the domesticeconomy. This raises the price of these goods leading to domestic goods again being equallycompetitive and attractive. Thus, domestic businesses are cushioned. These duties can be imposedunder the specifications given by the WTO (World Trade Organization) after the investigationfinds that exporters are engaged in dumping. These are also known as anti-dumping duties.School of Distance EducationInternational Economics Page 24Countervailing duties (CVD) are meant to level the playing field between domesticproducers of a product and foreign producers of the same product who can afford to sell it at alower price because of the subsidy they receive from their government. If left unchecked, suchsubsidized imports can have a severe effect on domestic industry, forcing factory closures andcausing huge job losses. As export subsidies are considered to be an unfair trade practice, theWorld Trade Organization (WTO) which deals with the global rules of trade between nations has detailed procedures in place to establish the circumstances under which countervailing dutiescan be imposed by an importing nation.The WTOs Agreement on Subsidies and Countervailing Measures, which is containedin the General Agreement on Tariffs and Trade (GATT) 1994, defines when and how exportsubsidies can be used and regulates the measures that nations can take to offset the effect of suchsubsidies. These measures include the affected nation using the WTOs dispute settlementprocedure to seek withdrawal of the subsidy, or imposing countervailing duties on subsidizedimports that are hurting domestic producers.The WTO only permits countervailing duties to be charged after the importing nation hasconducted an in-depth investigation into the subsidized exports. The agreement contains detailedrules for determining whether a product is being subsidized and calculating the amount of suchsubsidy, criteria for establishing whether these subsidized imports are affecting domestic industry,and rules for the implementation and duration of countervailing duties, which is typically fiveyears.Economic IntegrationA free trade area is a form of economic integration where in all barriers on trade amongmembers are removed, but each nation retains its own barriers on trade with the nonmembers. In afree trade area the group of countries will invoke little or no price control in the form of tariffs orquotas between each other. Free trade areas allow the agreeing nations to focus on theircompetitive advantage and to freely trade for the goods they lack the experience at making, thusincreasing the efficiency and profitability of each country. Eg: European Free Trade Association(EFTA in 1960) North American Free Trade Agreement (NAFTA in 1993) European Union (EU)formed in 1957.General Agreement on Tariff and Trade (GATT)GATT an international organization created in 1947. Its Head Quarters in Geneva(Switzerland), for the promotion of Free Trade through multilateral trade negotiations. Originallyit was thought that GATT would become part of the International Trade Organization (ITO).GATT was vested on three basic principles.i) Non discriminationii ) Elimination of NonTariff Tradeiii) Consultation among nations in solving trade disputes within the GATT frame work.School of Distance EducationInternational Economics Page 25European Union (EU)The E.U is also known as European common market. The European Union (EU) is aneconomic and political union of 28 member states that are located primarily in Europe. It wasfounded by the Treaty of Rome, signed in March 1957 by West Germany, France, Italy, andBelgium. In the intervening years the community and its successors have grown in size by theaccession of new member states and in power by the addition of policy areas to its remit. TheMaastricht Treaty established the European Union under its current name in 1993. The latestmajor amendment to the constitutional basis of the EU, the Treaty of Lisbon, came into force in2009.The EU has developed a single market through a standardized system of laws that apply inall member states. Within the Schengen Area (which includes 22 EU and 4 non-EU states)passport controls have been abolished. EU policies aim to ensure the free movement of people,goods, services, and capital, enact legislation in justice and home affairs, and maintain commonpolicies on trade, agriculture, fisheries, and regional development. The euro zone, a monetaryunion, was established in 1999 and came into full force in 2002. It is currently composed of 18member states. Through the Common Foreign and Security Policy the EU has developed a role inexternal relations and defence. Permanent diplomatic missions have been established around theworld. The EU is represented at the United Nations, the WTO, the G8, and the G-20. With acombined population of over 500 million inhabitants, or 7.3% of the world population, the EU in2012 generated a nominal gross domestic product (GDP) of 16.584 trillion US dollars,constituting approximately 23% of global nominal GDP and 20% when measured in terms ofpurchasing power parity, which is the largest nominal GDP and GDP PPP in the world.The North American Free Trade Agreement (NAFTA)NAFTA is an agreement signed by Canada, Mexico, and the United States, creating atrilateral rules-based trade bloc in North America. The agreement came into force on January 1,1994. The creation resulted in the formation of one of the worlds largest free trade zones therebylaying the foundations for strong economic growth and rising prosperity for Canada, the UnitedStates, and Mexico. Since then, NAFTA has demonstrated how free trade increases wealth andcompetitiveness, delivering real benefits to families, farmers, workers, manufacturers, andconsumers.In terms of combined purchasing power parity GDP of its members, as of 2007 the tradebloc is the largest in the world and second largest by nominal GDP comparison. All remainingduties and quantitative restrictions were eliminated, as scheduled, on January 1, 2008. NAFTAnow links 450 million people producing $17 trillion worth of goods and services.The Association of Southeast Asian Nations, (ASEAN)The Association of Southeast Asian Nations, or ASEAN, was established on 8 August1967 in Bangkok, Thailand, with the signing of the ASEAN Declaration (Bangkok Declaration)by the Founding Fathers of ASEAN, namely Indonesia, Malaysia, Philippines, Singapore andSchool of Distance EducationInternational Economics Page 26Thailand. Brunei Darussalam then joined on 7 January 1984, Viet Nam on 28 July 1995, Lao PDRand Myanmar on 23 July 1997, and Cambodia on 30 April 1999, making up what is today the tenMember States of ASEAN.Main objectives of the Association was to accelerate the economic growth, social progressand cultural development in the region through joint endeavors in the spirit of equality andpartnership in order to strengthen the foundation for a prosperous and peaceful community ofSoutheast Asian Nations. The association aims to promote active collaboration and mutualassistance on matters of common interest in the economic, social, cultural, technical, scientificand administrative fields. Also it intends to collaborate more effectively for the greater utilizationof their agriculture and industries, the expansion of their trade, including the study of theproblems of international commodity trade, the improvement of their transportation andcommunications facilities and the raising of the living standards of their subjects.The South Asian Association for Regional Cooperation (SAARC)The South Asian Association for Regional Cooperation (SAARC) is an economic andgeopolitical union of eight member nations that are primarily located in South Asia contingent. Itssecretariat is headquartered in Kathmandu, Nepal. The idea of regional political and economicalcooperation in South Asia was first coined in 1980 and the first summit held in Dhaka on 8December in 1985 led to its official establishment by the governments of Bangladesh, Bhutan,India, Maldives, Nepal, Pakistan, and Sri Lanka. In the intervening years, its successors havegrown in size by the accession of new member states. Afghanistan was the first to have beenaccessed in the physical enlargement of the SAARC in 2007.The SAARC policies aim to promote welfare economics, collective self-reliance amongthe countries of South Asia, and to accelerate socio-cultural development in the region. TheSAARC has developed a role in external relations around with world. Permanent diplomaticrelations have been established with the EU, the UN (as an observer), and other multilateralentities. On annual scheduled basis, the official meetings of leaders of each nation are held;meetings of foreign secretaries, twice annually. The next summit is expected to be held inKathmandu in 2013, but the official dates for the summit is yet to be determined.World Trade Organization (WTO)Internationally coordinated tariff reduction as a trade policy dates back to the 1930s. In 1930 theUnited States passed a tariff law known as the Smooth Hawley Law. Under the act the tariffs rosesharply. US Trade volume fell sharply. It is argued by many economists that the Act is the reason behindthe great depression of 1930s. US administration argued that the tariff should be reduced. But thereductions were not possible due to the pressure from the interested groups in Us states. The only possibleway is to go for bilateral negotiations. Such bilateral negotiations helped US to reduce their average levelof tariffs from 59% in 1932 to 25 percent in the II world war period. Multinational negotiations startedimmediately after the II world War. It was imagined that an international organisation called theInternational Trade Organisation (ITO) would be established along with the IMF and the World Bank. ButSchool of Distance EducationInternational Economics Page 27a group of 23 countries began the trade negotiations to establish the General Agreement on Tariff andTrade (GATT). GATT was an official Agreement and not an organisation. The countries participated in theagreement were known as the contracting parties. GATT maintained a permanent secretariat in Geneva. In1995 the World Trade Organisation (WTO) was established. The basic logic and the rules remains thesame.The World Trade Organization (WTO) deals with the global rules of trade between nations. Itsmain function is to ensure that trade flows as smoothly, predictably and freely as possible. The WorldTrade Organization (WTO) is the only global international organization dealing with the rules of tradebetween nations. At its heart are the WTO agreements, negotiated and signed by the bulk of the worldstrading nations and ratified in their parliaments.The following are the main methods in which the WTO system works:More openLowering trade barriers is one of the most obvious ways of encouraging trade; these barriersinclude customs duties (or tariffs) and measure such as import bans or quotas that restrict quantitiesselectively.Predictable and transparentForeign companies, investors and governments should be confident that trade barriers should notbe raised arbitrarily. With stability and predictability, investment is encouraged, jobs are created andconsumers can fully enjoy the benefits of competition choice and lower prices.More competitiveDiscouraging unfair practices, such as export subsidies and dumping products at below cost togain market share; the issues are complex, and the rules try to establish what is fair or unfair, and howgovernments can respond, in particular by charging additional import duties calculated to compensate fordamage caused by unfair trade.More beneficial for less developed countriesGiving them more time to adjust, greater flexibility and special privileges; over three-quarters ofWTO members are developing countries and countries in transition to market economies. The WTOagreements give them transition periods to adjust to the more unfamiliar and, perhaps, difficult WTOprovisions.Protect the environmentThe WTOs agreements permit members to take measures to protect not only the environment butalso public health, animal health and plant health. However, these measures must be applied in the sameway to both national and foreign businesses. In other words, members must not use environmentalprotection measures as a means of disguising protectionist policies.Trade negotiationsThe WTO agreements cover goods, services and intellectual property. They spell out theprinciples of liberalization, and the permitted exceptions. They include individual countriescommitments to lower customs tariffs and other trade barriers, and to open and keep open servicesSchool of Distance EducationInternational Economics Page 28markets. They set procedures for settling disputes. These agreements are not static; they arerenegotiated from time to time and new agreements can be added to the package. Many are nowbeing negotiated under the Doha Development Agenda, launched by WTO trade ministers inDoha, Qatar, in November 2001.Implementation and monitoringWTO agreements require governments to make their trade policies transparent bynotifying the WTO about laws in force and measures adopted. Various WTO councils andcommittees seek to ensure that these requirements are being followed and that WTO agreementsare being properly implemented. All WTO members must undergo periodic scrutiny of their tradepolicies and practices, each review containing reports by the country concerned and the WTOSecretariat.Dispute settlementThe WTOs procedure for resolving trade quarrels under the Dispute SettlementUnderstanding is vital for enforcing the rules and therefore for ensuring that trade flows smoothly.Countries bring disputes to the WTO if they think their rights under the agreements are beinginfringed. Judgements by specially appointed independent experts are based on interpretations ofthe agreements and individual countries commitments.Building trade capacityWTO agreements contain special provision for developing countries, including longertime periods to implement agreements and commitments, measures to increase their tradingopportunities, and support to help them build their trade capacity, to handle disputes and toimplement technical standards. The WTO organizes hundreds of technical cooperation missionsto developing countries annually. It also holds numerous courses each year in Geneva forgovernment officials. Aid for Trade aims to help developing countries develop the skills andinfrastructure needed to expand their trade.OutreachThe WTO maintains regular dialogue with non-governmental organizations,parliamentarians, other international organizations, the media and the general public on variousaspects of the WTO and the ongoing Doha negotiations, with the aim of enhancing cooperationand increasing awareness of WTO activities.Trade Rounds.These methods are used to improve the trade system through different Trade Rounds. In eachTrade rounds groups of countries get together to negotiate a set of tariff reductions and other measures toliberalize trade. Eight trade rounds have been completed since 1947. The last round was the Uruguay roundof trade negotiations in 1994. In 2001 there was the ninth round which is known as the Doha Round. Theeighth round of trade negotiations started in the year 1986 at Punta de Este in Uruguay. After Eight longyears of negotiations the participants could finally produce a document which is signed at Marrakesh inMorrocco.School of Distance EducationInternational Economics Page 29MODULE 4FOREIGN EXCHANGE MARKETMost countries have their own currencies, and when people in different countries dobusiness with each other, an exchange of currencies must take place. Foreign Exchange market isthe market for the purchase and sale of currencies. It is a global market which operates in all times(24x7 market). The price prevailing in this market is called foreign exchange rate. An exchangerate is the rate at which one currency can be exchanged for another. In other words, it is the priceof foreign currency in terms of the domestic currency. Just like the price of any asset, theexchange rate is the price at which one can buy another currency. Exchange rates are determinedin the foreign exchange market. Thus, economists predict that movements in exchange ratesshould reflect changes in the relative demand for and supply of the two currencies.Functions1. Fund TransferIt convenes the transfer of funds and purchasing power from one nation and currency toanother as foreign exchange is demanded to exchange commodities between nations. It is realizedthrough the inflow and outflow of money by exports and imports.2. Credit for TradeThe flow of goods and services across countries demand sufficient financial support.Through various monetary instruments like external commercial borrowing, Eurobonds, foreignbonds etc. foreign exchange market performs this function effectively.3. Hedging and SpeculationExchange rate risk is very fundamental to the foreign exchange market. The market itselfoffers ways to reduce or avoid it. Hedging means the measures adopted for avoiding risks. Butspeculation is an open position in the market with an expectation of gains through thefluctuations.PARTICIPANTS IN THE MARKETIt is an organizational framework within which individuals, firms and banks buy and sellforeign currencies or foreign exchange. This 24x7 hour market is the most liquid market in theworld level. It has global outreach and the currencies are traded worldwide. The differentmonetary centers are connected by a telephone network. Commercial banks, brokers and clientsare the major participants of this system. Exporters and importers are the real clients of themarket. Now a days speculators also involve in the market with an eye on the profit. Brokersintervene between the banks and clients. The regulators of the market are the banking systemconsisting of central banks and commercial banks. With the expansion of activities, corporate andnon banking financial intermediaries also actively take part in it.School of Distance EducationInternational Economics Page 30Fixed Exchange RatesThere are two ways the price of a currency can be determined against another. A fixed orpegged, rate is a rate the government (central bank)) sets and maintains as the official exchangerate. A rate will be determined against a major world currency (usually the U.S. dollar, but alsoother major currencies such as the euro, the yen or a basket of currencies). In order to maintain thelocal exchange rate, the central bank buys and sells its own currency on the foreign exchangemarket in return for the currency to which it is pegged.If, for example, it is determined that the value of a single unit of local currency is equal toUS$50, the central bank will have to ensure that it can supply the market with those dollars. Inorder to maintain the rate, the central bank must keep a high level of foreign reserves. This is areserved amount of foreign currency held by the central bank that it can use to release (or absorb)extra funds into (or out of) the market. This ensures an appropriate money supply, appropriatefluctuations in the market (inflation/deflation) and ultimately, the exchange rate.Floating Exchange RatesUnlike the fixed rate, a floating exchange rate is determined by the private market throughsupply and demand. A floating rate is often termed "self-correcting," as any differences in supplyand demand will automatically be corrected in the market. A floating exchange rate is constantlychanging. In a floating regime, the central bank may also intervene when it is necessary to ensurestability and to avoid inflation but the frequency is comparatively low.In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can alsoinfluence changes in the exchange rate. Sometimes, when a local currency reflects its true valueagainst its pegged currency, a "black market" (which is more reflective of actual supply anddemand) may develop. A central bank will often then be forced to revalue or devalue the officialrate so that the rate is in line with the unofficial one, thereby halting the activity of the blackmarket.EXCHANGE RATE REGIMES: HISTORICAL BACKGROUNDBetween 1870 and 1914, there was a global fixed exchange rate. Currencies were linked togold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces.This was known as the gold standard. This allowed for unrestricted capital mobility as well asglobal stability in currencies and trade. However, with the start of World War I, the gold standardwas abandonedAt the end of World War II, the conference at Bretton Woods, an effort to generate globaleconomic stability and increase global trade, established the basic rules and regulations governinginternational exchange. As such, an international monetary system, embodied in the (IMF), wasestablished to promote foreign trade and to maintain the monetary stability of countries andtherefore, that of the global economy. It was agreed that currencies would once again be fixed, orpegged, but this time to the U.S. dollar, which in turn was pegged to gold at US$35 per ounce.School of Distance EducationInternational Economics Page 31What this meant, was that the value of a currency was directly linked with the value of the U.S.dollar. So, if you needed to buy German marc, the value of the marc would be expressed in U.S.dollars, whose value in turn was determined in the value of gold. If a country needed to readjustthe value of its currency, it could approach the IMF to adjust the pegged value of its currency. Thepeg was maintained until 1971, when the U.S. dollar could no longer hold the value of the peggedrate of US$35 per ounce of gold. From then on, major governments adopted a floating system,and all attempts to move back to a global peg were eventually abandoned in 1985. Since then, nomajor economies have gone back to a peg, and the use of gold as a peg has been completelyabandoned.Countries with pegs are often associated with having unsophisticated capital markets andweak regulating institutions. The peg is there to help create stability in such an environment. Ittakes a stronger system as well as a mature market to maintain a float. When a country is forced todevalue its currency, it is also required to proceed with some form of economic reform, likeimplementing greater transparency, in an effort to strengthen its financial institutions.Some governments may choose to have a "floating," or "crawling peg, whereby thegovernment reassesses the value of the peg periodically and then changes the peg rateaccordingly. Usually, this causes devaluation, but it is controlled to avoid market panic. Thismethod is often used in the transition from a peg to a floating regime, and it allows thegovernment to "save face" by not being forced to devalue in an uncontrollable crisis.Advantages of floating exchange ratesFluctuations in the exchange rate can provide an automatic adjustment for countries with alarge balance of payments deficit. If an economy has a large deficit, there is a net outflow ofcurrency from the country. This puts downward pressure on the exchange rate and if depreciationoccurs, the relative price of exports in overseas markets falls (making exports more competitive)whilst the relative price of imports in the home markets goes up (making imports appear moreexpensive). This should help reduce the overall deficit in the balance of trade provided that theprice elasticity of demand for exports and the price elasticity of demand for imports aresufficiently high.A second key advantage of floating exchange rates is that it gives the government /monetary authorities flexibility in determining interest rates. This is because interest rates do nothave to be set to keep the value of the exchange rate within pre-determined bands. For examplewhen the UK came out of the Exchange Rate Mechanism in September 1992, this allowed a sharpcut in interest rates which helped to drag the economy out of a prolonged recession.The third important merit is that since adjustments are done automatically the cost of adjustmentwill be very low. It removes all the bottlenecks associated with frequent adjustments by themonetary authorities.School of Distance EducationInternational Economics Page 32Advantages of Fixed Exchange Rates (disadvantages of floating rates)Fixed rates provide greater certainty for exporters and importers and under normallycircumstances there is less speculative activity - although this depends on whether the dealers inthe foreign exchange markets regard a given fixed exchange rate as appropriate and credible.Sterling came under intensive speculative attack in the autumn of 1992 because the marketsperceived it to be overvalued and ripe for devaluation.DEVALUATION AND REVALUATIONUnder a fixed exchange rate system, devaluation and revaluation are official changes inthe value of a country's currency relative to other currencies. In a fixed exchange rate system, bothdevaluation and revaluation can be conducted by policymakers, usually motivated by marketpressures. Under a fixed exchange rate system, only a decision by a country's government ormonetary authority can alter the official value of the currency. Governments do, occasionally,take such measures, often in response to unusual market pressures. Devaluation, the deliberatedownward adjustment in the official exchange rate, reduces the currency's value; in contrast, arevaluation is an upward change in the currency's value. A key effect of devaluation is that itmakes the domestic currency cheaper relative to other currencies. There are two implications of adevaluation. First, devaluation makes the country's exports relatively less expensive forforeigners. Second, the devaluation makes foreign products relatively more expensive fordomestic consumers, thus discouraging imports. This may help to increase the country's exportsand decrease imports, and may therefore help to reduce the current account deficit.There are other policy issues that might lead a country to change its fixed exchange rate.For example, rather than implementing unpopular fiscal spending policies, a government mighttry to use devaluation to boost aggregate demand in the economy in an effort to fightunemployment. Revaluation, which makes a currency more expensive, might be undertaken in aneffort to reduce a current account surplus, where exports exceed imports, or to attempt to containinflationary pressures.Effects of DevaluationA significant danger is that by increasing the price of imports and stimulating greaterdemand for domestic products, devaluation can aggravate inflation. If this happens, thegovernment may have to raise interest rates to control inflation, but at the cost of slower economicgrowth.Another risk of devaluation is psychological. To the extent that devaluation is viewed as asign of economic weakness, the creditworthiness of the nation may be jeopardized. Thus,devaluation may dampen investor confidence in the country's economy and hurt the country'sability to secure foreign investment.School of Distance EducationInternational Economics Page 33Another possible consequence is a round of successive devaluations. For instance, tradingpartners may become concerned that devaluation might negatively affect their own exportindustries. Neighboring countries might devalue their own currencies to offset the effects of theirtrading partner's devaluation. Such "beggar thy neighbor" policies tend to exacerbate economicdifficulties by creating instability in broader financial markets.Under a floating exchange rate system, market forces generate changes in the value of thecurrency, known as currency depreciation or appreciation. Depreciation is the downward trendwhereas appreciation is the upward trend in rate of exchange.THEORIES OF EXCHANGE RATEThere are two prominent theories which determine exchange rate systematically goldstandard and purchasing power parity theory.Purchasing-power parity theoryPurchasing power parity is both a theory about exchange rate determination and a tool to makemore accurate comparisons of data between countries. It serves as a tool for cross-countrycomparisons of income and wages, which is used by international organizations like the WorldBank in presenting much of their international data. The concept of purchasing power parity isquite old. It is believed to have been propounded by the sixteenth-century scholars of theUniversity of Salamanca of Spain.It relates the price level in a country to the exchange rate. Purchasing power parity(PPP) is a theory of exchange rate determination which compares the average costs of goods andservices between countries. The theory states that the exchange rate between one currency andanother is in equilibrium when their domestic purchasing powers at that rate of exchange areequivalent. PPP indicates that exchange rate between two countries should equal to the ratio ofsimilar goods and services in both countries. In short, what this means is that a bundle of goodsshould cost the same in India and Pakistan when we take the exchange rate between them.Purchasing-power parity theory tells us that price differentials between countries are notsustainable in the long run as market forces will equalize prices between countries and changeexchange rates in doing so. Since the price for any one good should be equal across markets, theprice for any combination or basket of goods should be equalized.PPP calculated by comparing price of one good across in different currencies is known asAbsolute PPP. For example, if one kg of wheat costs INR 12 in India and similar quality of wheatcosts 2 dollars in USA, then the PPP exchange rate would be INR 6 per USD. This is the absoluteversion of theory of purchasing power of parity.School of Distance EducationInternational Economics Page 34Another form of less stringent PPP stresses on comparing price index of basket of goods inboth countries rather than comparing any one good/service. There is an alternative version of thePPP theory called the relative PPP theory. In essence this is a dynamic version of the absolutePPP theory In other words; the spot rate between two countries can be determined by comparingthe price index of a basket of similar goods and services. It is very important to understand at thispoint is that price index should comprise of similar goods & services consumed by residents ofboth country. If the actual spot exchange rate equals the rate calculated by PPP, then PPP holdstrue. However, it is empirically proved that PPP in absolute form based on single product or basedon a price index does not hold good.Problems with the PPP TheoryThe main problem with the purchasing power parity (PPP) theory is that the PPP conditionis rarely satisfied within a country.Transportation costs and trade restrictionsThese mean that there can be no tariffs on imports or other types of restrictions on trade.Since transport costs and trade restrictions do exist in the real world, this would tend to driveprices for similar goods apart. Transport costs should make a good cheaper in the exportingmarket and more expensive in the importing market. Similarly, an import tariff would drive awedge between the prices of an identical good in two trading countries markets, raising it in theimport market relative to the export market price. Thus the greater transportation costs and traderestrictions are between countries, the less likely for the costs of market baskets to be equalized.Costs of non tradable inputsMany items that are homogeneous nevertheless sell for different prices because theyrequire a non tradable input in the production process. As an example, the same food item will becharged at two different prices at a local hotel and a five star restaurant. The increased rate of rentand more comfortable hospitality will be added to the cost of menu causing a higher charge in therestaurant. They cant discount this as it is a part of their production. At this stage prices wouldnot be equalized.Perfect informationThe law of one price assumes that individuals have good, even perfect, information aboutthe prices of goods in other markets. Only with this knowledge will profit seekers begin to exportgoods to the high price market and import goods from the low-priced market. Consider a case inwhich there is imperfect information. Perhaps some price deviations are known to traders butother deviations are not known, or maybe only a small group of traders know about a pricediscrepancy and that group is unable to achieve the scale of trade needed to equalize the prices forthat product. (Perhaps they face capital constraints and cant borrow enough money to finance thescale of trade needed to equalize prices.) In either case, traders without information about pricedifferences will not respond to the profit opportunities and thus prices will not be equalized. Thusthe law of one price may not hold for some products, which would imply that PPP would not holdeither.School of Distance EducationInternational Economics Page 35Other market participantsNotice that in the PPP equilibrium stories, it is the behavior of profit-seeking importersand exporters that forces the exchange rate to adjust to the PPP level. These activities would berecorded on the current account of a countrys balance of payments. Thus it is reasonable to saythat the PPP theory is based on current account transactions. This contrasts with the interest rateparity theory in which the behavior of investors seeking the highest rates of return on investmentsmotivates adjustments in the exchange rate. Since investors are trading assets, these transactionswould appear on a countrys capital account of its balance of payments. Thus the interest rateparity theory is based on capital account transactions.It is estimated that there are approximately $12 trillion dollars worth of currencyexchanged every day on international foreign exchange (Forex) markets. Thats one-eighth ofU.S. GDP, which is the value of production in the United States in an entire year. In addition, the$12 trillion estimate is made by counting only one side of each currency trade. Thus thats anenormous amount of trade. If one considers the total amount of world trade each year and thendivides by 365, one can get the average amount of goods and services traded daily. This number isless than $100 billion dollars. This means that the amount of daily currency transactions is morethan ten times the amount of daily trade. This fact would seem to suggest that the primary effecton the daily exchange rate must be caused by the actions of investors rather than importers andexporters. Thus the participation of other traders in the Foreign exchange market, who aremotivated by other concerns, may lead the exchange rate to a value that is not consistent withPPP.PPP is based on the concept of Law of One Price. The LOOP indicates that identicalgood/services should sell for the same price in two separate markets when there are notransportation costs and no differential tax rates exists in the two markets. If there is a pricedifference, then exchange rate would move in such a manner so that, in both markets the productwill sell at same price. The law of one price says that identical goods should sell for the sameprice in two separate markets when there are no transportation costs and no differential taxesapplied in the two markets.The LOOP holds well only if three conditions are satisfied. These three are: Transportation costs, barriers to trade (import-export levies, customs duty etc) and othertransaction costs (currency conversion fee) are insignificant. There must be competitive markets for the goods and services in both countries. The LOOP applies only to tradable goods. LOOP is not applicable to immobile goods suchas houses and many services that are local in nature.School of Distance EducationInternational Economics Page 36Mint Parity TheoryMint parity theory explains the determination of exchange rate between the two countrieswhich are on gold standard. In a country which is on gold standard, the currency is either made ofgold or is convertible into gold at a fixed rate. There are also no restrictions on the export orimport of gold. The central bank of the country was always ready to buy and sell gold at thespecified price. The rate at which the standard money of the country was convertible into goldwas called mint price of gold.Determination of Exchange Rate.The rate of exchange between the gold standard countries is determined on a weight toweight basis of the gold contents of their currencies. In other words, the exchange rate isdetermined by the, gold equivalents of the currencies involved. For examples, before World War-ll (1926-1931) England and American currencies were on gold standard. The mint par betweenthese two countries was pound one of England=4.86 dollars of America. The rate of exchangeshowed that one pound of England contained as much fine gold as 4.866 dollars contained inAmerica. The ratio of weights of metal was called the mint parity.The mint par was a fixed rate. It remained constant so long as the monetary laws of thecountry remained unchanged. The current or the market rate of exchange, however, fluctuatedfrom time to time due to changes in the balance of payments of the respective countries. Thevariations in the exchange rate remained within the well defined limits called gold points or speciepoints. The gold points refer to the limits within which the market rate of exchange between twogold standard countries fluctuates from the mint parity equilibrium. The upper gold pointindicates the upper limit and the lower gold point indicates the lower limit.Calculations of gold points.But the actual rate of exchange could very above and below the mint parity by the cost ofshipping gold between the two countries The gold points are determined by the costs oftransporting gold (such as shipping, packing, insurance charges, etc.) from one country toanother. The upper gold point (upper specie point) is obtained by adding the cost of shipping goldto the mint parity rate of exchange. The lower gold point (lower specie point) is arrived at bydeducting the cost of shipping gold from the mint parity rate of exchange. For example, the mintparity rate of exchange between England and America is 1=$4.866. The shipping cost of goldfrom America to England worth 4.866 dollars of gold is .02 cent. In that case the upper gold point= 1=$4.866 + .02=$4.886. The lower gold point = 1$4.866 .02= $4.846.Gold export point and gold import point.The upper gold point is also called gold export point. It is the rate of exchange above which thegold will be exported. The lower gold point is also called the gold import point. It is the rate ofexchange below which gold will be imported. Under the gold standard, the exchange rate betweenthe two currencies cannot vary above the upper gold point and below the lower gold point as isillustrated in the figure.School of Distance EducationInternational Economics Page 37In the figure the demand curve DD and supply curve DD intersect each other at point R. OR isthe exchange rate between the dollar and the pound. It may here be noted that the exchange rateneed not be at the mint parity. It can be anywhere between the upper and lower gold pointsdepending on the shape of demand and supply curves. An American importer would not pay morethan $4.886 to obtain one pound of England. It is because he can purchase $4.866 worth of goldfrom the US Treasury and ship it to England at a cost of .02 cent per pound. The exchange rate,therefore, cannot rise beyond the gold export point OU. The supply curve of pounds becomesperfectly elastic at the US gold export point.Similarly, the rate of exchange cannot fall between $4846 to a pound. The exchange rate of $4846to a pound is the US gold import point. In case of lower rate, the Americans would prefer to usethe pounds to import gold from England. The Americans demand curve for pounds becomesperfectly elastic at the gold import point OL. The mint parity theory has long been discarded eversince the gold standard broke down. Now no country is on the gold standard. So it has anacademic curiosity only.DrawbacksThe gold standard has only limited applicability in the present world.This will function only undergold base standard. It fails to explain the determination of exchange rate in the present dayfloating system.COMPONENTS OF FOREIGN EXCHANGE RESERVESForeign exchange reserves are the financial hoardings of a country to intervene or supportits external economic transactions at times of necessity. Since US dollar is the dominant vehiclecurrency, generally foreign exchange reserves are denominated in terms of it. At times of foreignexchange risk or BOP crisis central banks and governments intervene and smoothen out theturbulence using this reserve. It is an important indicator of external economic health of a country.It mainly consists of four components- gold reserves held by the central bank, stock of foreigncurrencies, reserve tranche position in IMF and the holding of IMF currency (Special DrawingRights). In India RBI keeps 557.75 tonnes gold as reserve. Foreign currency holdings are kept bythe central bank in the form of US dollar, Euro, Pound Sterling and Japanese Yen. These are usedfor open market operations and other intervening activities. Reserve tranche position is theborrowal facility offered by the IMF to the member countries. Using it a country can borrow upto25% of its quota(which is equal to its gold subscription and hence also called gold tranche)unconditionally. SDR is the reserve asset created by IMF in 1967 and provided to the membersproportionate to their quotas. This accounting money is also called paper gold and is not used as acirculating currency.School of Distance EducationInternational Economics Page 38MODULE 5BALANCE OF PAYMENTSThe Balance of Payments is a systematic records of all economic transactionsbetween residents of the reporting Country & residents of foreign countries.- KindlebergerIntroduction:-Balance of Payment (BOP) is a summary statement of all economic transactions of theresidents of a nation with the residents of Rest of the World (ROW) during a particular period oftime. BOP is recorded usually for a Calendar year. In other words B O P is a systematic statisticalstatement or record of the character and dimensions of the countrys economic relationship withthe rest of the world. Balance of payments is integral parts of national accounts for an openeconomy.The main purpose of the Balance of Payment is to inform the Government of theinternational economic position of the nation and to help in formulating its of monitory, fiscal andtrade policies. The Foreign Governments also use the Balance of Payment accounts for thepurpose of formulating trade relation with other countries. Other economic agents like Bank firmsand individual may also depend upon the Balance of Payment accounts for various purposes.The Balance of Payment account serves another purpose. The balance of Countrys foreigntransactions and accompanying issues of the exchange date and reserves (whether of Gold or offoreign currencies) has long been a focus of interest for policy members. Thus the state of B.O.Pplays an essential role in providing information to economic agents and Governments. Accordingto Sodersten,the B.O.P is nearly a way of listing receipts and payments in internationaltransactions for a countryThe Balance of Payment account have significant role in an open economy. An open economyis one which has economic relations with the rest of the world. An economic transaction is anexchange of value, involving a payment or receipts of money in exchange of a good, a service oran asset for which payment is made between the resident of a country with resident of the rest ofthe world. In barter trade, goods are exchanged for goods and in some cases assets aretransacted against assets. Some goods are transferred to other as a gift, without expecting paymentknown in economics as the transfer payments or unilateral transfers. Each of these transactionsoccurs between the residents of a country and between the economic agents residing in twodifferent countries. If the exchange is happening between the residents of two countries, thattransaction in an International economic transaction. An international economic transaction issystematically recorded in the books of accounts of balance of payments. Balance of paymentsare maintained in a Double entry book keeping principle. Under such principle each transactionis the balance of payments is entered as a Credit or a Debit entry. A Credit entry in Balance ofPayments refers to an inflow or that transaction is the one that shows a receipt of funds from therest of the world. Similarly a Debit entry Balance of Payments refers to an outflow or thatSchool of Distance EducationInternational Economics Page 39transaction is the one that shows a payment of funds to the rest of the world. According to theDouble entry book keeping principle, for each Debit entry a corresponding Credit entry is made tokeep the balance of payment always in balance.In the above flow chart diagrams the 1stflow shows an inflow of value which may appear as aCredit entry in the books of accounts of Balance of payments on the Domestic Country. ThisInflow of value includes the receipts that the Resident of the domestic territory gets in return forthe Export of commodities or Services (also known as the invisibles), unilateral transfers and theForeign Capital receipts. 2ndflow shows an outflow of value. This may appear as a Debit entry inthe books of accounts of Balance of payments of the Domestic Country. This outflow of valueincludes the payments that the Resident of the domestic territory makes in return for the Importsof commodities or Services (also known as the invisibles), unilateral transfers and the Investmentsabroad.Balance of payments and balance of tradeAll countries engaging in International Exchange of value may import some commoditiesand services from other countries. They also export certain other commodities and services whichare surplus in their country. The difference between the value of goods and services exported outof a country and the value of goods and services imported into the country in known as theBalance of Trade. If a country has a balance of trade deficit, it imports more than it exports, and ifit has a balance of trade surplus, it exports more than it imports. The balance is said tobe favorable when the value of the exports exceeded that of the imports (i.e. exports exceedimports), and unfavorable when the value of the imports exceeded that of the exports (i.e. importsexceed exports). In other words it is the difference between the value of goods and servicesResident of theROWI. Inflowor CreditII.Outflowor DebitResident oftheDomesticNationSchool of Distance EducationInternational Economics Page 40exported out of a country and the value of goods and services imported into the country. Thebalance of trade is the official term for net exports that makes up the balance of payments. Theofficial balance of trade is separated into the balance of merchandise trade for tangible goods andthe balance of services.A balance of trade surplus is most favorable to domestic producers responsible for theexports. However, this is also likely to be unfavorable to domestic consumers of the exports whopay higher prices. Alternatively, a balance of trade deficit is most unfavorable to domesticproducers in competition with the imports, but it can also be favorable to domestic consumers ofthe exports who pay lower prices.The difference between the Balance of Payments and Balance of trade can be explained with thehelp of the below given table.Balance of Trade (BOT)Balance of Payment (BOP)Balance of Trade is defined as 'differencebetween export and import of goods andservices'Balance of Payment includes not only importand export of goods and services but alsofinancial / capital transfer.BOT = Net Earning on Exports - Net paymentmade for importsBOP = BOT + (Net Earning on foreigninvestment i.e. payments made to foreigninvestors) + Cash Transfer + Capital Account+or - Balancing ItemorBOP = Current Account + Capital Account +or - Balancing item ( Errors and omissions)If export is more thanimport, at that time, BOT will be favorable. Ifimport is more than export, at that time, BOTwill be unfavorable.Balance of Payment will be favorable, if thecountry has surplus in current account forpaying your all past loans in her capitalaccount. Balance of payment will beunfavorable, if country has current accountdeficit and it took more loan from foreigners.After this, it has to pay high interest on extraloan and this will make BOP unfavorable.Need not be in balance always Balance of payments to be in balance always.Following are main factors which affect BOTa) cost of productionb) availability of raw materialsc) Exchange rated) Prices of goods manufactured at homeFollowing are main factors which affect BOPa) Conditions of foreign lenders.b) Economic policy of Govt.c) all the factors of BOTSchool of Distance EducationInternational Economics Page 41Balance of payment AccountingBalance of Payments is essentially maintained in double entry book keeping principle. Theyrecord all international transactions between the residents of one country with the residents ofother countries. Here residents refer to the individuals, business and governments and theiragencies. International organizations are also regarded as foreign residents. Balance of paymentaccounts are kept in standard Double entry book keeping principle. International transactions arerecorded in the balance of payments as a credit and a debit transaction. Credit transaction is thattransaction which involves the receipt from the residents of the rest of the world. A debittransaction on the other hand involves a payment to the foreign residents. Under this method, eachinternational transaction undertaken by the residents of a country are entered as a debit and creditentry of equal size, into the balance of payments. For example an export entered as credit in acountries balance of payment is followed by a debit entry of equal size, to show the manner inwhich the transaction is undertaken. Import transactions are entered as a debit transaction in thebalance of payments and a credit entry of equal size is made in the books of account.On the basis of its value 3 possibilities are there. They are: If Debit balance > Creditbalance it leads to Balance of Payment deficit. Here the inflow will be lesser than the outflow.Hence the nation experiences a deficit in its Balance of Payment accounts. On the other hand ifthe Debit balance < Credit balance we have a Balance of Payment Surplus. Here the outflow willbe lesser than the inflow. If Debit balance = Credit balance then we can say that the nationsBalance of Payment is in balance.Balance of Payment Accounts consists of the two sub accounts. They are Current accountand Capital Account. Current account includes visible items (commodities) and Invisible items(Services). Capital account consists of long term and short term capital flows. Let us explain themin detail.THE CURRENT ACCOUNTThe current account includes exports and imports of goods and services & unilateraltransfers. Exports, weather it is goods or services are by convention entered as a credit items inthe account. Imports are normally calculated free on board. That means that the cost oftransportation, insurance etc are not included. Imports are normally calculated c.i.f (cost,insurance, freight). Transportation, insurance cost and fright are included.Balance of payment accounts usually make differences between trade in goods and tradein services. In the current account of Balance of payment accounts, we have a visible part ofcommodities and Invisibles part of Services. The net of exports and import of visibles inBalance of payment accounts is called the merchandise trade balance. The net of exports andimport of invisibles or services in Balance of payment accounts is called the services tradebalance. Travel, Business Process outsourcing, Medical Transcription etc are examples forinternational trade in Services. The Capital account, on the other hand, consists of long term andshort term capital flows. Let us explain them in detail.School of Distance EducationInternational Economics Page 42Invisible trade is much more hetnogenious them the trade in goods. Trade in the latter, ofwhich shipping, banking and insurance services and payments by residents as tourists abroad areusually the most important, Exports and imports of such services are flows of outputs whosevalues will be determined by the same variable that could affect the demand on supply for goodsunilateral transfer or transfer payments.Unilateral transfers are receipts which the residents of a country receive for free, withoutmaking any present or future service transaction in return. Unilateral receipts from abroad areentered as positive items and they are credited. Unilateral payments abroad are entered asnegative items and they are debited. Unilateral transfers may be private unrequited transfers,which may be in the form of gifts received by domestic residents from foreign residents. Secondlyofficial unrequited transfers, is the payment of pure aid by governments in developed countries togovernment in less developed countries (LDCs) . A third form of unilateral transfer has beenimportant reparation payments. Typically such payments occurred when a morally and physicallysuperior country came out of war and was in a position to make the foreign country or its formerenemy pay indemnities.The net value of the balance of visible trade and invisible trade and of unilateral transfersdefined the balance on current account. It is, however, services and transfer payments or invisibleitems of the current account that reflect the true picture of the balance of payments account. They,along with the visible items, determine the actual current account position. If export of goods andservices exceed import of goods and services, the balance of payments is said to be favorable. Inthe opposite case, it is unfavorable. In the current account, the exports of goods and services andthe receipts of transfer payments are entered as credit because they represent the receipt fromforeigners. On the other hand, the imports of goods and services and transfer of payments toforeigners are entered as debits because they represent payments to foreigners.THE CAPITAL ACCOUNTThe capital account records all international financial transactions that involve resident ofthe country concerned- changing either his assets with or his liabilities to a resident of anothercountry. Transactions in the capital account reflect change in a stock either assets or liabilities.It is often useful to make distinctions between various forms of capital account transactions. Thebasic distinctions are between private and official transaction; between portfolio and directinvestments. Distinction between private and official transaction is fairly transparent and need notconcern us too much. On the other hand, portfolio investments are the acquisition of an asset thatdoes not give the purchaser control over it. An example is the purchase of shares in a foreigncompany or of bonds issued by a foreign government Loans made to foreign firms orgovernments come into the same broad category. Foreign Direct investment (FDI) is the act ofpurchasing an asset and at the same time accruing control of it. The acquisition of a firm residingin one country by a firm in another country is an example.School of Distance EducationInternational Economics Page 43The purchase of an asset in another country whether it is direct or portfolio investment ,would appear as a debit item in the capital account for the country of the firm which purchase itand as a negative item in the capital account for the other country . The capital account outflowsappear as a debit item in countrys balance of payments and capital inflows as credit items. Thenet value of the balance of direct and portfolio investment defines the balance on capital account.ERRORS AND OMISSIONSThe balances of payments accounts are completed by the entering some other minor itemsthat can be identified but do not fall comfortably into one of the standard categories. Errors andomissions, which reflect transactions that have not been recorded for various reasons and cannotbe entered under a standard heading, may cause Errors and omissions. Balance of payments isconstructed as an accounting identity with each transaction theoretically recorded twice, the sumtotal of debits and credits should in theory always be equal. That means that if a debit entry ismade to record an outflow of value, a corresponding credit entry is to be made in some other partof the books of account for theoretically maintaining balance in the books of accounts of thebalance of payments. However one or other of the parts of transaction takes more than one year.discrepancy may arise and the Balance of payment may not balance.OFFICIAL RESERVES ACCOUNTThe official reserves account measures the changes in the official reserves and changes theforeign official assets in the country during the year. Official reserves consist of gold, SpecialDrawing Rights (SDRs) borrowed from the IMF, and holding of foreign convertible currencies.The changes in the countrys reserves must reflect he net value of all the other recorded items inthe balance of payments. These changes will of course be recorded accurately, and it is thediscrepancy between the changes in reserved and the net value of the other recorded items thatallows identifying the errors and omissions.Increase in official reserves represents capital outflows from the country and are recordedas debits in the official reserves accounts of the books of accounts of Balance of Payments of thecountry. Any decrease in the official reserves is recorded as capital inflows and are credit entriesin the reserves accounts of the books accounts of Balance of Payments of the country. The entriesare similar to that of private capital but we are here dealing with the official capital. The items ofthe balance of payments account of the country can be noted (distinguishing credits and debits) asshown below:School of Distance EducationInternational Economics Page 44Capital AccountCapital payments (DirectInvestment, Portfolio Investment)& other capital payments abroad.Capital Receipts ( DirectInvestment, Portfolio Investment)and other capital receipts.Current AccountImport of GoodsImport of ServicesUnrequited PaymentExport of GoodsExport of ServicesUnrequited ReceiptsBalance ofPaymentsSchool of Distance EducationInternational Economics Page 45Autonomous and Accommodating FlowIt is useful to distinguish between autonomous and accommodating items in the balance ofpayments. All transactions in the current and capital account are called automatic transactions.Transactions are said to be autonomous if their value is determined independently of the balanceof payments. They take place for business or private motive. Accommodating items aretransactions that come under the official reserve account and are determined by the netconsequences of the autonomous items. They are required to balance international transactions.Alternatively items are said to be above the line (autonomous) or below the line(accommodating). Obviously the sum of the accommodating and autonomous items must be zero,since all entries in the balance of payment s accounts must come under one of the tw3o headings.A deficit in a nations balance of payments is given by a net debit balance in the nationsautonomous items and a surplus is given by a net credit balance. In order to correct the deficit theaccommodating flows to be positive in the first case and negative in the second.The autonomous capital flow could take many forms. It could have been caused, forinstance, by a foreign resident paying back a loan to a firm or it could be that a person or acompany took up a loan abroad, by issuing bonds for instance. In all these cases it is a question ofprivate persons or firms having international capital transaction. These transactions have an effecton the countrys balance of payments but they are in no way caused by balance of paymentsconsiderations. In fact, they are all examples of autonomous capital movements.The accommodating inflow of capital can take various forms. Foreign firms might acceptshort term claims on firms in the country or perhaps a foreign government extends a loan to thecountry. In the case of a less developed country, it might even be possible that a foreigngovernment is willing to ease the balance of payments situation of the country by making it a giftamounting to the value of the accommodating inflow. Or possibly the county in question has hadto deplete its reserves of foreign currency to settle its imbalance in autonomous capital inflow. Inshort the accommodating capital movements are a direct consequence of the balance of paymentssituation. Accommodating capital inflows are unforeseen capital flows, which have to be made tobring the balance of payments into equilibrium.Official ReserveaccountsOfficial Reserve liabilities.Official Reserve assetsSchool of Distance EducationInternational Economics Page 46EQUILIBRIUM AND DISEQUILIBRIUM IN THE BALANCE OF PAYMENTS.Balance of payments should always be in equilibrium. Disequilibrium in the balance ofpayments of a country appears either as a surplus or as a deficit. A Surplus in the balance ofpayments implies receipts from the rest of the world exceed payments made to rest of the world.A Deficit in the balance of payments occurs as the payments made to foreigners exceed receiptsfrom the Rest of the world. As a BOP is in equilibrium any positive balance in its current accountsin exactly offset by a negative balance on its capital account and vice versa. In an accountingsense, the balances of payments always balance.There is difference of opinion with regard to the primary cause of imbalances in Balanceof Payments. Conventionally it is beloved that the factors with regard to the current accounts arethe primary causes of imbalance. They include the appreciation or a depreciation of exchangerate, the government's fiscal deficit, business competitiveness, and private behavior such as thewillingness of consumers take debt to finance extra consumption. An alternative view, as arguedby Ben Bernanke, the chairman of the American Federal Reserve, in a 2005 paper, is that theprimary driver of Balance of payment deficit is the capital account. He maintained that the causeof Balance of payment disequilibria of US is a global savings glut which caused a runs ahead ofsavers in surplus countries, over the available investment opportunities, which resulted in excessconsumption and asset price inflation.MEASURES TO CORRECT BALANCE OF PAYMENT DISEQUILIBRIUM.Persistent disequilibrium in the balance of payments, particularly a deficit in balance ofpayments, is undesirable because it (a) weakens the country's economic position at theinternational level, and (b) affects the progress of the economy adversely. It must be cured bytaking appropriate measures. There are many measures to correct disequilibrium in the balance ofpayments. Important among them are discussed below:1. Deflation:In the wake of Deficit in a nations Balance of Payments it can resort to tight monetary policy.The currency authority may try to lower the prices by reducing the quantity of money incirculation or follow a deflationary monetary policy. Deflation is the classical medicine forcorrecting the deficit in the balance of payments. Deflation refers to the policy of reducing thequantity of money in order to reduce the prices and the money income of the people. This is doneby the central bank of the country through raising the bank rate, by selling the securities in theopen market and by other methods can reduce the volume of credit in the economy which willlead to a fall in prices and money income of the people. Fall in prices will stimulate exports andreduction in income checks imports. Thus, deflationary policy restores equilibrium to the balance(a) by encouraging exports through reduction in their prices and (b) by discouraging importsthrough the reduction in incomes at home. Moreover, a higher interest rate in the domestic marketSchool of Distance EducationInternational Economics Page 47will attract foreign funds which can be used for correcting disequilibrium. However, deflation isnot considered a suitable method to correct adverse balance of payments because of the followingreasons: (a) Deflation means reduction in income or wages which is strongly opposed by the tradeunions, (b) Deflation causes unemployment and suffering to the working class, (c) In a developingeconomy, expansionary monetary policy rather than contractionary (deflationary) monetary policyis required to meet the developmental needs.2. Depreciation:Another method of correcting disequilibrium in the balance of payments is depreciation orappreciation of the exchange rate. Deprecation means a fall in the rate of exchange of onecurrency (home currency) in terms of another (foreign currency). A currency will depreciate whenits supply in the foreign exchange market is large in relation to its demand. In other words, acurrency is said to depreciate if its value falls in terms of foreign currencies, i.e., if more domesticcurrency is required to buy a unit of foreign currency. An appreciation on the other hand is therise in the value of a currency relative to the foreign currency. Depreciation helps a country toachieve a favorable balance of payments by checking imports and stimulating exports. Thefollowing are the defects of this method(i) It is not suitable for a country which follows a fixed exchange rate system.(ii) It makes international trade risky and thus reduces the volume of trade.(iii) The terms of trade go against the country whose currency depreciates because the foreigngoods have become costlier than the local goods and the country has to export more to pay for thesame volume of imports.(iv) Experience of certain countries has indicated that exchange depreciation may generateinflationary pressure by increasing the domestic price level and money income.(v) The success of the method of exchange depreciation depends upon the cooperation of othercountries. If other countries also start depreciating their exchange rates, then these methods willnot benefit any country.3. Devaluation:Devaluation refers to the official reduction of the external values of a currency. The differencebetween devaluation and depreciation is that while devaluation means the lowering of externalvalue of a currency by the government, depreciation means an automatic fall in the external valueof the currency by the market forces; the former is arbitrary and the latter is the result of marketmechanism.Thus, devaluation serves only as an alternative method to depreciation. Both the methods implythe same thing, i.e., decrease in the value of a currency in terms of foreign currencies.School of Distance EducationInternational Economics Page 48Both the methods can be used to produce the same effects; they discourage imports, encourageexports and thus lead to a reduction in the balance of payments deficit.The success of the method of devaluation depends upon the following conditions :(i) The elasticity of demand for the country's exports should be greater than unity.(ii) The elasticity of demand for the country's imports should be greater than unity.(iii) The exports of the country should be non-traditional and the increasingly demanded fromother countries.(iv) The domestic price should not rise and should remain stable after devaluation.(v) Other countries should not retaliate by resorting to corresponding devaluation. Such aretaliatory measure will offset each other's gain.Devaluation also suffers from certain defects:(i) Devaluation is a clear revelation on the country's economic weakness.(ii) It reduces the confidence of the people in country's currency and this may lead to speculativeoutflow of capital.(ii) It encourages inflationary tendencies in the home country.(iv) It increases the burden of foreign debt.(v) It involves large time lag to produce effects.(vi) It is a temporary device and does not provide a permanent remedy to correct adverse balanceof payments.4. Exchange Control:Exchange control is the most widely used method for correcting disequilibrium in the balance ofpayments. Exchange control refers to the control over the use of foreign exchange by the centralbank. Under this method, all the exporters are directed by the central bank to surrender theirforeign exchange earnings. Foreign exchange is rationed among the licensed importers. Onlyessential imports are permitted. Exchange control is the most direct method of restricting acountry's imports. The major drawback of this method is that it deals with the deficit only, and notits causes. Rather it may aggravate these causes and thus may create a more basic disequilibrium.In short, exchange control does not provide a permanent solution for a chronic disequilibrium.5. TariffsTariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of importswould increase to the extent of tariff. The increased prices will reduced the demand for importedgoods and at the same time induce domestic producers to produce more of import substitutes.Non-essential imports can be drastically reduced by imposing a very high rate of tariff.School of Distance EducationInternational Economics Page 49Drawbacks of Tariffs :-1. Tariffs bring equilibrium by reducing the volume of trade.2. Tariffs obstruct the expansion of world trade and prosperity.3. Tariffs need not necessarily reduce imports. Hence the effects of tariff on the balance ofpayment position are uncertain.4. Tariffs seek to establish equilibrium without removing the root causes of disequilibrium.5. A new or a higher tariff may aggravate the disequilibrium in the balance of payments of acountry already having a surplus.6. Tariffs to be successful require an efficient & honest administration which unfortunately isdifficult to have in most of the countries. Corruption among the administrative staff willrender tariffs ineffective.6. QuotasUnder the quota system, the government may fix and permit the maximum quantity or value of acommodity to be imported during a given period. By restricting imports through the quota system,the deficit is reduced and the balance of payments position is improved.Types of Quotas :-1. the tariff or custom quota,2. the unilateral quota,3. the bilateral quota,4. the mixing quota, and5. import licensing.Merits of Quotas :-1. Quotas are more effective than tariffs as they are certain.2. They are easy to implement.3. They are more effective even when demand is inelastic, as no imports are possible abovethe quotas.4. More flexible than tariffs as they are subject to administrative decision. Tariffs on theother hand are subject to legislative sanction.Demerits of Quotas :-1. They are not long-run solution as they do not tackle the real cause for disequilibrium.2. Under the WTO quotas are discouraged as they are constraints on free trade.We examined the method of correcting a deficit in a nations current account or balance ofpayments by depreciation or a devaluation of the nations currency. Depreciation implies aflexible exchange rate system. Devaluation, on the other hand, refers to the deliberate (policy)increase in the exchange rate by the nations monetary authorities from one fixed or pegged levelto another. However since both a depreciation and a devaluation operate on prices to bring aboutadjustment in the nations current account and the balance of payments, they are both referred toas the price adjustment mechanism.School of Distance EducationInternational Economics Page 50Balance Of Payments Adjustments with Exchange Rate ChangesUnder flexible exchange rates, the disequilibrium in the balances of payments isautomatically solved by the forces of demand and supply for foreign exchange. An exchange rateis the price of a currency which is determined, like any other commodity, by demand andsupply.The exchange rate varies with varying supply and demand conditions, but it is alwayspossible to find an equilibrium exchange rate which clears the foreign exchange market andcreates external equilibrium. This is automatically achieved by a depreciation (or appreciation)of a countrys currency in case of a deficit (or surplus) in its balance of payments. Depreciation(or appreciation) of a currency means that its relative value decreases (or increases).depreciationhas the effect of encouraging exports and discouraging imports. When exchange depreciationtakes place, foreign prices are translated into domestic prices.Suppose the Rupee depreciates in relation to dollar. It means that the price of a rupee fallsin relations to the dollar in the foreign exchange market. For example assume that the value ofIndian currency was around Rs 40 =1$ in 2008. Imagine that there is a deficit in Indias BOP.Deficit is due to large imports compared to its imports. In 2013, depreciation of Indian rupeecaused the exchange rate to increase to RS 68 =1$. This causes exports to increase and imports tofall. In 2008 an Indian citizen could purchase 1 $ worth commodity with Rs 40, but the samedollar worth commodity is worth RS 68 today. Hence the Imports fall and exports increases. TheBalance of payment moves back to equilibrium. The effect of depreciation of a currency is tomake imports dearer and exports cheaper. Thus, this leads to the lowering of the prices of Indianexports in US and raising the prices of US imports in the India. When import prices are higher inthe India, Indians will purchase fewer goods from the U S. On the other hand, lower prices ofIndian exports will increase their sales to U S. Thus the India exports will increase and importsdiminish, thereby bringing equilibrium in the balance of payments.ASSUMPTIONSThe analysis is based on the following assumptions1. There are only two countries.2. Both are on flexible exchange rate system3. BOP disequilibrium is automatically adjusted by changes in exchange rates4, Prices are flexible in both the countries5. There is free trade between the two countriesGiven these assumptions, the adjustment process is explained in terms of the followingSchool of Distance EducationInternational Economics Page 51In the above figure D is the Indian demand curve of U S $ which id a derived demand from thedemand for U S imports, and S is the U.S. supply curve of foreign exchange representing itsexports to India.FIGURE 1At p the demand and supply of the Indian foreign exchange is in equilibrium where the rate ofexchange between Indian Rupee and US $ is op and the quantity of exchange is odd=oss. If theexchange rate is at p1 the demand for U S dollar is greater than its supply. This implies that theimport from US is greater than exports, and hence a deficit in Indias BOP. This causes the Rupeeto depreciate and the exchange rate finally sets at p and BOP reaches back to equilibrium. Thecurrency needs t be depreciated by p1p amount for the BOP to be in balance. The exact oppositehappens when the exchange rate is at p2 (a surplus in BOP).The above analysis based on the assumptions of relative elasticity of demand and supplyof foreign exchange. However, in order to measure the full effect of depreciation on relativeprices in the Balance of payment of the country we have to take the impact of these elasticity also.It is not necessary that the demand and supply conditions to be relatively elastic as shown in theabove diagram. N additional demand and supply curve as illustrated in the below given diagramrequires more depreciation to correct the disequilibrium in the BOP.School of Distance EducationInternational Economics Page 52FIGURE 2Where the original less elastic demand and supply curves of foreign exchange are d and srespectively which intersect at p and the equilibrium exchange rate is op. Here the new sets ofdemand and supply curves (d and s) intersects at a higher point ie eand p1p depreciation isinsufficient to bring about equilibrium in the BOP. here we need p1p2 depreciation in thedomestic currency. Hence greater depreciation is needed when the Demand and Supply of foreigncurrency is relatively inelastic.Automatic price adjustment under gold standardUnder the international gold standard which operated between 1880-1914, the currencyin use was made of gold or was convertible in to gold at fixed rate. The central bank of thecountry was always ready to buy and sell gold at the specified price. The rate at which thestandard money of the country was convertible into gold was called the mini price of gold. Thisrate was called the mint parity or mint par of exchange because it was based on the mint parity bythe cost of shipping gold between the two countries.Suppose the US had a deficit in its balance of payments with Britain. The differencebetween the value of imports and exports would have to be paid in gold by US importers becausethe demand for pounds exceeded the supply of pounds. But the transhipment of gold involvedtransportation cost and other handling charges ,insurance,etc. Suppose the shipping cost of goldfrom the US to Britain was 3 cents. So the importers would have to spend $6.03($6+.03c) forgetting1. This could be the exchange rate which was the US gold export point or upper specieSchool of Distance EducationInternational Economics Page 53point. No US importer would pay more than $6.03 to obtain 1 because he could buy $6 worth ofgold from the US treasury and ship it to Britain at a cost of 3 cents per ounce. Similarly, theexchange rate of the pound could not fall below $5.97 to a pound was the US gold import point orlower specie point. The exchange rate under the gold standard was determined by the forces ofdemand and supply between the gold points and was prevented from moving outside the goldpoints by shipments of gold. The main objective was to keep BOP in equilibrium. Deficit orsurplus in BOP under the gold standard was automatically adjusted by the price-specie-flowmechanism. For instance, BOP deficit of a country meant a fall in its foreign exchange reservesdue to an outflow of its exports and reduce its imports. This adjustments process in BOP wassupplemented by a rise in interest rates as a result of reduction in money supply. This led to theinflow of short-term capital from the surplus country. Thus the inflow of short-term capital fromthe surplus to the deficit country helped in restoring BOP equilibrium.Adjustment mechanism of balance of payments under income approachIn examining the price adjustment mechanisms, we implicitly assumed that nationalincome remained constant. However, a change in the level of trade affects national income, whichin turn induces a change in the value of imports. For example starting from an equilibriumposition in the balance of trade and less than full employment domestically, an autonomousincrease in the value of exports causes real national income (Y)to rise by an amount equal to theincrease in X times the foreign trade multiplier k,if the marginal propensity to save orMPS=S/=0,then k=1/MPM, where is the marginal propensity to import ,OR M/Y. In thiscase, the induced increase in M resulting from the increase in Y equals the original autonomousincrease in X , and so the adjustment in the balance of payments in complete .if ,on the otherhand (more realistically)MPS>0,K=1/(MPS+MPM) and the induced increase in M falls shorts ofthe increase in X and the adjustment is incompleteTRENDS IN INDIAS BOPThe true index of economic prosperity or disparity of a country in relation to the other countries ofthe world is provided by the balance of payments account. A typical problem of the developing countries isthat of a chronic BOP deficit, India being no exception. This mainly due to unequal sharing of gain fromtrade, deterioration in underdeveloped countries Terms of Trade. India has been facing BOPdisequilibrium right since independence, culminating into a disaster in 1990-91, the year of the acute BOPcrisis. Indian foreign reserves fell below $1billion, barely sufficient to finance a months import bill. Indiaapproached the International Bank for Reconstruction and Development (IBRD), popularly known asWorld Bank and the International Monetary Fund (IMF),and received $7billion as loan to manage thecrisis. For available the loan, these international agencies expected India to liberalise and open up theeconomy by removing restrictions on the private sector , reduce the role of the government in many areasand remove trade restrictions.School of Distance EducationInternational Economics Page 54BOP situation pre-reform periodThe Indias BOP always under pressure and had huge deficits due to high imports of food grainsand capital goods, the heavy external borrowings and its payment and poor exports. Indias aim afterattaining independence was to attain economic self- reliance. For this the country had to tap both theinternal as well as the external resources. Not only was our technology backward then, there was foodscarcity too. Large amounts of food grains had to be imported to feed the huge population. Self reliancewas to be achieved through import substitution. For this basic industries had to be set up which requiredimport of capital goods. . Heavy capital goods were imported but other imports were severely restricted toshut off competition in order to promote domestic industries. All focus was on import substitution, withgross neglect of exports. Such inward looking protectionist policies did result in some self-reliance in theconsumer goods industries, but the capital goods industries remained mostly import intensive. The highdegree of protection to Indian industries led to inefficiency and poor quality products due to lack ofcompetition. The high cost of production further eroded our competitive strength. These are the someinternal factors that causes for the deficit in BOP.Rising petroleum products demand, the two oil shocks, harvest failure, all put severe strainon the economy. The BOP situation remained weak throughout the 1980s, till it reached the crisissituation in 1990-91.When India was on the verge of defaulting due to heavy debt burden andconstantly widening trade deficit. India had to resort to large scale foreign borrowings for itsdevelopmental efforts in the field of basic social and industrial infrastructure. The countrysresources were very much limited due to low per capita income and savings. The situationworsened because Government of India resorted to heavy foreign borrowings to correct the BOPsituation in the short run out of panicky. By 1985-1990 India had to resort to large scale foreignborrowings for its developmental efforts in the field of basic social and industrial infrastructure.The countrys resources were very much limited due to low per capita income and savings. Thesituation worsened because Government of India resorted to heavy foreign borrowings to correctthe BOP situation in the short run out of panicky.India mainly primary product exporters, the price of which fluctuated heavily withfluctuations in world market demand. Primary products exporting countries have an unfavorableterm of trade. The earnings from primary product exports were low and unstable. The quality ofIndian products was not up to the world standards due to which we could not sustain markets. Theinstability of the exchange value of the rupee was another problem. The constant devaluations (topromote exports) raised the amount of external debt. The value of rupee was managed by thecentral bank (fixed exchange rate).The strict foreign exchange controls also encouraged hawalatrade.India followed a strongly inward looking policy, laying stress on import substitution.Ideally, imports should be financed by export earnings. But because there was export pessimism,the deficit was financed either by the invisible earnings or by foreign aid or depletion of valuableforeign exchange reserve. Indias BOP was thus beset with several problems. The process ofliberalization began from the mid 1980s. Restriction on certain imports were removed,particularly those which were used as inputs for export production. But by then the situation wasalready bad and all the mismanagement ultimately led to the 1990-91 BOP crisis.School of Distance EducationInternational Economics Page 55TRENDS IN INDIAS BOP POST ANDPRE REFORMPERIODSIt is clear from the Table1 the Balance of Payment situation started improving since 1991 exceptfor the years 1995-96 and 2008-09 . The reasons for satisfactory performance of BOP are as follows :-1. High earnings from invisibles : The positive earnings from invisibles covered a subpart of thetrade deficit with the result that the account deficit was reduced significantly. Earning invisiblesexceeds the deficit on trade account in 2001-02,2002-03and 2003-04 with the result that theresurplus on current account in these years. The software exports and private remittances that arethe main new contributors to improve in the balance of payment situation recently.2. Rise in external commercial borrowing: External commercial borrowings have been animportant source of funds for the government. Over the years the net external commercialborrowings have increased. In 1991-92 the external commercial borrowing was$1456 million.During 2001-02 to 2003-04 external commercial borrowing were negative. During 2007-08, theexternal commercial borrowing were $22609 million which was 21.0 percent or one-fifth of totalcapital inflow(net). In 2008-09 ,external commercial borrowings were only $7941 million3. Non-Resident deposits: The non-resident deposits add to the capital account of BOP. In 1990-91,non-resident deposits (net) were 1.5 US $ billion, which increased to 2.9 US $ billion in 2009-10.The various schemes of incentives announced by Indian government helped in attracting hugedeposits from non-resident Indians.4. Role of Foreign Investment: Foreign investment is constituted of (1)foreign direct investmentand (2) portfolio investment. portfolio investment, in turn consists of (a) foreign institutionalinvestment and (b) euro equities and others (which includes Global Depository Receipts (GDRs),American Depository Receipts (ADRs) and Offshore funds and others).Since 1991 the govt hasbeen offering various concessions, facilities and incentive to the foreign investors with a view toencouraging foreign investment into the country. These measures have helped in increasingforeign investment substantially in the recent years. In 1993-94, the foreign was $4,235 millionwhich was 43 percent of the total capital inflows(net) of $9882 million in the country. In 2002-03it was $4161 million and rose to $14753 million in 2007-08 and $3467 million in 2008-09because of Global recession investors withdrawal of portfolio investment.School of Distance EducationInternational Economics Page 56Table1 India's BOP Indicators (1980-2012) ( US $ million)Year\ItemsTradeBalanceNetInvisiblesBalance cura/cBalance capa/cOverallbalanceReserve(-increase)1980-81 -7869 5065 -2804 1665 -1140 6541981-82 -7273 4094 -3179 657 -2523 18121982-83 -6978 3572 -3407 2087 -1319 -6491983-84 -6714 3499 -3216 2655 -561 -7501984-85 -5654 3238 -2417 3147 730 -7791985-86 -7833 2967 -4867 4506 -361 5771986-87 -7316 2756 -4560 4512 -47 5731987-88 -7168 2316 -4852 5047 195 7371988-89 -9361 1364 -7997 8064 68 10011989-90 -7456 615 -6841 6977 136 7401990-91 -9437 -242 -9680 7188 -2492 12781991-92 -2798 1620 -1178 3777 2599 -33841992-93 -5447 1921 -3526 2936 -590 -6981993-94 -4056 2897 -1159 9694 8535 -87231994-95 -9049 5680 -3369 9156 5787 -46441995-96 -11360 5447 -5912 4690 -1222 29371996-97 -14815 10196 -4619 11412 6793 -58181997-98 -15507 10008 -5499 10010 4511 -38931998-99 -13246 9208 -4038 8260 4222 -38291999-00 -17841 13143 -4698 11100 6402 -61422000-01 -12460 9794 -2666 8535 5868 -58422001-02 -11574 14974 3400 8357 11757 -117572002-03 -10690 17035 6345 10640 16985 -169852003-04 -13718 27801 14083 17338 31421 -314212004-05 -33702 31232 -2470 28629 26159 -261592005-06 -51904 42002 -9902 24954 15052 -150522006-07 -61782 52217 -9565 46171 36606 -366062007-08 -91467 75731 -15737 107901 92164 -921642008-09 -119519 91605 -27915 7835 -20079 200802009-10 -118202 80022 -38180 51622 13441 -134412010-11 -130593 84648 -45945 58996 13050 -130502011-12 -189759 111604 -78155 65324 -12832 12831Source: RBI, Hand book of statistics on Indian EconomyFrom the table-1 it is clear that Indias trade balance shows a deficit through out all years, which is shownin the figure-1.The intensity of deficit, shows an increasing rate. It is because of a continuous and fasterincrease in import compared to its export. After 2004-05 Indias trade balance shows a much more higherSchool of Distance EducationInternational Economics Page 57deficit mainly due to increase in crude oil price in international market, depreciation of Indian currencywhich worsen the import bill, fall in export earnings due the financial crisis.(table-3, Fig-3)Indias current account also reflects a continuous deficit in all years except 2001-02 , 2002-03, 2003-04.Itis because of strong capital inflows during that periods. It is shown in fig-2.Current account deficit iscomparatively low when we compared to trade deficit it is because higher earnings from invisibles whichcovers huge part of trade deficit.In capital account all years appear with a surplus value. There is a low capital inflow during 2008-09periods because of high withdrawal of portfolio investment due the financial crisis. It also affects overallbalance of payment of our country. The overall balance of payment of our county shows a fluctuatingtends. In 1980-81 to 1983-84, 1985-86 to 1986-87, 1990-91, 1996-97, 2008-09 and 2011-12 shows adeficit trend.Fig-1Fig-2-100000-50000050000100000150000Yearscura/c bal & cap a/c balanceIndia's Current & Capital a/c (1980-2012)Balance cur a/cBalance cap a/c-250000-200000-150000-100000-50000050000100000150000YearsTrade balance & Net invisiblesIndia's Trade balance & Net invisibles (1980-2012)Trade BalanceNet InvisiblesSchool of Distance EducationInternational Economics Page 58Fig-3Fig-4CONCLUSIONThe balance of payment of a country is a systematic record of all economic transactions betweenthe residents of the country and the rest of the world. It presents a classified record of all receipts onaccount of goods exported, services rendered and capital received by residents and the payments made bythem on account of goods imported and services received and capital transferred to non-residents orforeigners. (Balance of Payment manual for India, September 2010). The main purpose of the balance ofpayment is to inform the govt of the international position of the nations and to help it its formulation ofmonetary, fiscal and trade policies.The transactions are presented in forms of double-entry book keeping.That means the transactions are classified as credit or debit. Credit transactions are those that involve thereceipts of payments from foreigners. The export of goods and services, unilateral transfers from foreignersand capital inflows are credited and entered with a positive sign. Debit transactions are those that involvethe making payments to foreigners. The import of goods and services, unilateral transfers to foreigners, andcapital outflows are debited and entered with a negative sign. Each transaction is recorded twice, once as acredit and once as a debit of an equal amount. This is known as double-entry book keeping. If a nationsinflows are greater than its outflows (credit > debit) the BOP said to be in surplus. If a nations outflowsare greater than its inflows (debit> credit) the BOP said to be in deficit.-150000-100000-50000050000100000150000over